Session 13&14&15 Flashcards
1
Q
Primary market
A
The primary market is the part of the capital market that deals with issuing of new securities. Companies, governments or public sector institutions can obtain funds through the sale of a new stock or bond issues through primary market.
=!secondary market (sometimes exchange markets but mostly dealer markets)
2
Q
Call market
A
A market in which trading in individual securities occurs at specific times as opposed to continuously. In a call market all orders to buy and sell a particular security are assembled at one time in order to determine a price at which most of the orders can be executed. The participants then move on to a different security. Call markets are frequently used in situations in which there are few securities and participants.
3
Q
Continuous market
A
A continuous market can occur at any time as long as the market is open. Buyers and sellers are matched up on a continuous basis and the price is determined through an auction or through bid-ask quotes.
4
Q
Long position
A
gains when asset values increase.
purchase stock or calls, sell puts, take long futures or forward positions
5
Q
Short position
A
gains when asset values decrease.
sell short, sell/write calls, purchase puts, take short futures or forward positions)
6
Q
Calls (call options)
A
right to buy
7
Q
Puts (put options)
A
right to sell
8
Q
Buying on margin
A
The purchase of an asset by paying the margin and borrowing the balance from a bank or broker. Buying on margin refers to the initial or down payment made to the broker for the asset being purchased. The collateral for the funds being borrowed is the marginable securities in the investor’s account. Before buying on margin, an investor needs to open a margin account with the broker. In the U.S., the amount of margin that must be paid for a security is regulated by the Federal Reserve Board.
9
Q
Trading execution
A
How to trade:
market order
limit order
10
Q
Trading validity
A
When to trade: good-till-canseled immediate-or-cansel = fill or kill day order stop order
11
Q
Seasoned offering
A
An issue of additional securities from an established company whose securities already trade in the secondary market. A seasoned issue is also known as a “seasoned equity offering” or “follow-on offering.”
12
Q
Quote driven market
A
An electronic stock exchange system in which prices are determined from bid and ask quotations made by market makers, dealers or specialists. In a quote driven market, also known as a price driven market, dealers fill orders from their own inventory or by matching them with other orders. A quote driven market is the opposite of an order driven market, which displays individual investors’ bid and ask prices and the number of shares they want to trade.
13
Q
Order driven market
A
A financial market where all buyers and sellers display the prices at which they wish to buy or sell a particular security, as well as the amounts of the security desired to be bought or sold. This is the opposite of a quote driven market, which is one that only displays bids and asks of designated market makers and specialists for a specific security.
14
Q
Rebalancing
A
The process of realigning the weightings of one’s portfolio of assets. Rebalancing involves periodically buying or selling assets in your portfolio to maintain your original desired level of asset allocation.
15
Q
Stock split
A
Take, for example, a company with 100 shares of stock priced at $50 per share. The market capitalization is 100 × $50, or $5000. The company splits its stock 2-for-1. There are now 200 shares of stock and each shareholder holds twice as many shares. The price of each share is adjusted to $25. The market capitalization is 200 × $25 = $5000, the same as before the split. –> dilution does not occur.
16
Q
Price weighted index
A
A stock index in which each stock influences the index in proportion to its price per share (represents a portfolio which includes an equal number of shares of each stock in the index). The value of the index is generated by adding the prices of each of the stocks in the index and dividing them by the total number of stocks. Stocks with a higher price will be given more weight this way and, therefore, will have a greater influence over the performance of the index.
17
Q
Market cap weighted index
A
represents a portfolio that includes all the outstanding shares of each stock in the index
Price and outstanding shares today /
price and outstanding shares base year
beginning index value (100, 1000, …)
18
Q
Risk adjusted return
A
Risk-adjusted return is a measure of the return on an investment relative to the risk of that investment, over a specific period.
it’s used to compare different investments with different returns and risks.
one of the calculation methods is Sharpe ratio:
portfolio return - risk free return /
portfolio standard deviation
19
Q
Momentum investing (strategy)
A
This strategy looks to capture gains by riding “hot” stocks and selling “cold” ones. To participate in momentum investing, a trader will take a long position in an asset, which has shown an upward trending price, or short sell a security that has been in a downtrend. The basic idea is that once a trend is established, it is more likely to continue in that direction than to move against the trend.
20
Q
Statutory voting
A
if you owned 50 shares and were voting on six board positions, you could cast 50 votes for each board member, for a total of 300 votes. You could not cast 20 votes for each of five board members and 200 for the sixth.
21
Q
Cumulative voting
A
lets shareholders weight their votes toward particular candidates and improves minority shareholders’ chances of influencing voting outcomes. In cumulative voting, you are allowed to vote disproportionately, so if you own 50 shares and are voting on six board positions, you can cast 300 votes for one director and none for the five other directors.
22
Q
Callable common stock
A
A security that represents ownership in a corporation that has voting rights, whose owners are last to be paid if the company liquidates and which is redeemable by the issuing corporation, at a predetermined price or at a premium to the current market price. Typically, callable common stock is issued for a subsidiary company by its parent company. The parent company reserves the right to buy back the shares of the subsidiary company, should it become strategically beneficial.
opposite: putable
23
Q
Callable common stock
A
A type of preferred stock in which the issuer has the right to call in or redeem the stock at a preset price after a defined date.
opposite: putable
24
Q
Leveraged buyout (LBO)
A
a private equity technique
uses debt to buy all outstanding stock of a firm
25
Management Buyout (MBO)
an LBO led by firm's management
26
Private investment in public entity
A private investment firm's, mutual fund's or other qualified investors' purchase of stock in a company at a discount to the current market value per share for the purpose of raising capital.
27
Depository receipts
a type of foreign investment.
A negotiable financial instrument issued by a bank to represent a foreign company's publicly traded securities. A depository receipt trades on a local stock exchange, but a custodian bank in the foreign country holds the actual shares. Depository receipts can be sponsored or unsponsored depending on whether the company that issued the shares enters into an agreement with the custodian bank that issues the depository receipt.
For example, a firm based in Kenya looking to list shares in the United States through an ADR will pick a Kenyan bank to serve as a custodian of the firm's shares. Once the bank is chosen, the firm will decide how many shares will be represented by the depository receipt, referred to as the depository receipt ratio, and will find an American broker willing to purchase the shares to be held by the custodian bank. Once the bank issues depository receipts, the American broker can sell those shares domestically.
28
Premium
Bond price > par value
29
Coupon rate
ANNUAL interest rate (frequency is not that much important, there's no compounding and the annual sum would be constant)
30
Bond indenture (trust deed)
legal contract between issuer and bond holder, held by trustee.
it includes covenants
* debenture: an unsecured loan certificate issued by a company, backed by general credit rather than by specified assets.
31
Affirmative/negative covenants
A: actions that issuer must perform
N: restrictions on issuer actions that would disadvantage bondholders
32
Domestic/foreign bonds
| National bond market
D: Domestic issuer and currency
F: Foreign issuer - Local currency (german firm registers with SEC and issue $ bonds in US)
N: market including trading of both issue types
33
Eurobonds
Usually, a eurobond is issued by an international syndicate and categorized according to the currency in which it is denominated. A eurodollar bond that is denominated in U.S. dollars and issued in Japan by an Australian company would be an example of a eurobond. The Australian company in this example could issue the eurodollar bond in any country other than the U.S.
**eurobonds are traded in eurobond markets not national markets, if a eurobond is at least traded in one domestic market, it's named global bond.
34
Securitized bond
Issued by a special purpose entity(SPE)
firm sells assets to the SPE (bankuptcy remote)
these assets are the bond's collateral and also asset cash flows make payments to bond holders.
this is mechanism to reduce borrowing costs by making the bondholder's claim on a solid collateral which is bankruptcy remote.
*Assets like MBS, credit card receivables, business loans and automobile loans are used.
35
Covered bonds
like securitized bonds but they don't sell to SPEs, the asset is still on company's balance sheet but it's segregated.
in this model, firm must augment assets whenever they are insufficient to support covered bonds (maybe due to value fall).
also in this type bondholders have recourse to the firm as well as the segregated financial assets. because they're still related to the firm. so covered bonds are a bit stronger than securitized bonds.
36
Credit enhancement
Internal: overcollateralization/excess spread/tranches (waterfall structure)
External: bank guarantee/surety bond/letter of credit/cash collateral account
37
OID bonds
original issue discount bonds:
| bonds issued with discount to par value, most extreme example is zero coupon bond
38
Fixed income cash flows
```
Fixed:
Bullet Structure
Partially amortizing
Fully amortizing
Sinking fund
```
Floating:
Floating rate notes(FRN): reference rate + fixed margin (could have a cap or floor)
Variable rate note: margin not fixed (e.g may change with the rate of the bond)
Inverse floater: coupon rate = X% - reference rate
Other terms:
Step up coupon: coupon rate (fixed or floating) increases on a schedule, likely the issuer calls the bond prior to step up unless rates are up or credit rating down (so the issuer cannot have a cheaper source of finance)
Credit linked coupon: coupon rate increases if credit rating decreases and vice versa.
Payment in kind: Issuer may make coupon payments by increasing principal amount.
Deferred (split) coupon: Coupon payments do not begin until a period after issuance, then the accrued coupon payment would be paid, and after that regular coupon payments until maturity.
Index linked bonds: coupon rate or principal changes based on value of an index (CPI, Equity indices like SP500 (usually zero coupon bonds!), commodity prices, ...)
Inflation linked bonds(linkers):
(adjusted based on CPI)
Interest indexed: coupon rate adjusted
Capital indexed: principal value adjusted
Indexed annuity bonds: fully amortizing, payments adjusted
Principal protected: pay original face value if index decreases over life of bond
39
LIBOR
is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. It stands for IntercontinentalExchange London Interbank Offered Rate and serves as the first step to calculating interest rates on various loans throughout the world.
40
Embedded options in bonds
Callable bonds
(*make whole provisions: calculate call price based on future cash flows)
Putable bonds
Convertible Bonds (bondholder decides)
Warrants (attaching stock options to the bond!)
Contingent convertibles (converts automatically if specific events like a fall in company equity percentage happen)
41
Fixed income classifications
Type of issuer: government/ corporate/ SPE(SPV)/ structured finance instruments
Credit Quality: Investment grade/high yield/speculative/junk
Maturities: Money market/capital market
Coupon structure: Fixed rate/floating rate
Geographic market: developed/emerging
Currency denomination: primarily dollar and euro
Index linking: inflation/equities/commodities
Taxable status:exempt/OID/interest paid net of tax
42
Primary markets for bonds
Public offering
Private placement
Shelf registration: register entire issue with regulators, issue bonds over time
Underwritten offering
Best effort offerings
Auctions: often used for government bonds (single price auctions)
43
Secondary market for bonds + trade settlement
Primarily over the counter trading (dealer market) and the bid-ask spread depends on issue's liquidity.
trade settlement:
T+3: corporate bonds
T+1: government bonds
Same day (cash settlement): money market securities
*bonds are priced based on their value on the delivery date
44
Government debt
Soveregin bond: issued by national government in local currency or a foreign currency (higher ratings when in local currency, because they can simply print it if needed!)
Non sovereign government bonds: States, provinces, counties, cities (higher ratings when coupons are going to be paid from taxes, fees, etc than from the project earnings because it could be late, problems could come up, etc).
45
Agency debt
Quasi government bonds(agency bonds): issued by government sponsored entities (they could be guaranteed by the government or not)- like fannie mae
Supranational bonds: issued by multilateral agencies, like IMF or world bank
46
Corporate debt
Bank borrowing: Bilateral loans-Syndicated loans
```
Commercial papers (working capital financing-bridge financing): US CP(up to 270 days-traded based on discounts- Settlement in T+0) / Euro CP(up to 364 days-traded based on add-on interest basis-Settlement in T+2)
**Rollover risk: the risk that new CP cannot be issued(sold) to pay for maturing paper-this can happen due to deteriorating credit of the company or systematic failure of the market) --> of a good credit ratings company's need backup lines of credit
```
Corporate bonds: Term maturity structure/Serial bond issue
Medium term notes(MTNs): not medium term and not notes:D
Issuer provides range of maturities, buyer specifies desired value and maturity through issuer's agent.
47
Short term funding for banks
Customer deposits
Certificate of deposit
Negotiable CDs (large numbers-traded on secondary markets-- a 1 million CD means we should pay 1M right now and receive 1M+interest at maturity)
Central bank funds market (loans from CB to meet reserve requirements-- short term borrowing and lending among banks of their excess funds deposited with central banks)
Interbank funds (like CB funds- banks like it more because it doesn't reveal their liquidity needs)
48
Repurchase agreements
Source of short term funding for bond dealers.
| sell bond to counterparts and agree to repurchase it on repo date at a slightly higher price (repo rate)
49
Reverse repo
looking at repo from dealer's perspective.
| dealers needs a specific bond in his inventory so buys it and promises to sell it back at a defined price
50
Repo margin
= haircut
you are not going to be loaned the whole value of the bond (collateral) because of the risks
*repo margin: percentage difference between sale price and value of bond.
51
Repo margin and rate sensitivity
Bond credit, counterpart credit(seller of bonds), term of repo, securities supply
52
YTM assumes:
Held to maturity
All payments made
Coupon payments reinvested at YTM
53
Spot rates
a market discount rate for a single payment to be received in the future. (yields on zero coupon bonds are spot rates)
YTM is an average of spots, its just the IRR achieved when chipping in the current price!)
54
Accrued interest
accrued interest interest in the bond's price that is being traded in between coupons.
30/360 method: usually for corporate bonds
actual/actual method: government bonds
55
Flat/full price
flat=clean=quoted--> does not include accrued interest.
full=invoice=dirty--> includes accrued interest
56
Matrix pricing
used to price bonds that are not frequently traded so no access to YTM.
uses YTMs of traded bonds of same credit quality to estimate bond YTM (ONLY the credit quality is important to be the same)
average of YTMs of bonds with same maturity or use linear interpolation to adjust for differences in maturities.
57
YTM for semiannual pay bonds
2*semiannual IRR
(not an EAY)
--> semi annual pricing uses YTM/2
58
Current yield
annual coupon payment/flat price
*current yield ignores movement toward par value(amortization)
59
Simple yield
(annual coupon payment +/- amortization) / flat price
* amortization: (discount or premium) / time to maturity
* assumes straight line amortization of premium or discount
60
Yield convention
Street convention: payments on scheduled dates
True yield: uses actual payment dates (differences can occur due to holidays and weekends)
Government equivalent yield: corporate bond yield restated based on 365 day year, used for calculating spread to benchmark government bond yield
61
Yield to call (YTC)
With discount bonds there's no problem, we get to the par value sooner so higher yield.
Yield to first call: substitute the call price at the first call date for par and number of periods to the first call date for N
*Different YTCs can be calculated for each of a bond's call dates
62
Yield to worst
the lowest of YTM and the YTCs for all the call dates and prices
63
Option adjusted yield
more precise yield measure for callable bonds:
1. value the call option using a pricing model and expected yield volatility
2. add the call option value to the bond price
3. calculate the option adjusted yield using the option adjusted price
Now we can compare Option adjusted yield of the callable bond with the YTM of the bond.
**for putable: subtract the value of the put
64
Floating rate notes
coupon at next reset date(coupon date) = reference rate at previous reset rate +- quoted margin
65
Required margin
* related to FRN yields
* discount margin
the margin that would cause the note's value to return to par at the reset date, may differ from quoted margin if issuer's credit quality changes.
**specified yield spread over the reference rate is called the quoted margin on the FRN. The role of the quoted margin is to compensate the investor for the difference in the credit risk of the issuer and that implied by the reference rate. For example, a company with a stronger credit rating than that of the banks included in Libor may be able to obtain a “sub-Libor” cost of borrowed funds, which results in a negative quoted margin. An AAA rated company might be able to issue an FRN that pays three-month Libor minus 0.25%.
**Suppose that a traditional floater is issued at par value and pays three-month Libor plus 0.50%. The quoted margin is 50 bps. If there is no change in the credit risk of the issuer, the required margin remains at 50 bps. On each quarterly reset date, the floater will be priced at par value. Between coupon dates, its flat price will be at a premium or discount to par value if Libor goes down or up. However, if the required margin continues to be the same as the quoted margin, the flat price is “pulled to par” as the next reset date nears. At the reset date, any change in Libor is included in the interest payment for the next period.
66
Money market instruments yield
quoted as simple annual interest
* There are several important differences in yield measures between the money market and the bond market:
1. Bond yields-to-maturity are annualized and compounded. Yield measures in the money market are annualized but not compounded. Instead, the rate of return on a money market instrument is stated on a simple interest basis.
2. Bond yields-to-maturity can be calculated using standard time-value-of-money analysis and with formulas programmed into a financial calculator. Money market instruments often are quoted using nonstandard interest rates and require different pricing equations than those used for bonds.
3. Bond yields-to-maturity usually are stated for a common periodicity for all times-to-maturity. Money market instruments having different times-to-maturity have different periodicities for the annual rate.
67
Compare money market instruments
money market instruments have lots of different terms, so:
compare them based on bond equivalent yield- add on yield based on 365 day year
*A bond equivalent yield is a money market rate stated on a 365-day add-on rate basis.
68
Periodicity of money market instruments
365/days to maturity
kollan periodicity mishe tedad dafaati ke tuye sal sud mide.
69
Yield curves
=term structure
shows yields for bonds(same bond) with different maturities.
70
Forward rates (notation)
2y3y: 3 year rate(annualized rate), two years from now
Sn: N year spot rate = N years rate, right now --> we can calculate forward rates from spot rates or vice versa
71
Yield spread
allow the separation of changes in risk free rates from changes in yield premiums for credit risk, liquidity, and other bond differences
**RFR driven by macroeconomic factors and Spreads driven by microeconomic factors.
**Spread represents the difference in credit risk and liquidity
**The yield spread is the additional compensation required by investors for the difference in the credit risk, liquidity risk, and tax status of the bond relative to the government bond.
72
G-spreads
bond yield - benchmark government risk free bond (same maturity)
73
I-spreads
Interpolated spreads
? Eurozone bonds with spreads defined in accordance to fixed for floating swap.
an I-spread is the spread over or under an interest rate swap rate. it uses rate for interest rate swaps in the same currency and with the same tenor as the benchmark.
**The yield spread of a specific bond over the standard swap rate in that currency of the same tenor is known as the I-spread or interpolated spread to the swap curve. This yield spread over Libor allows comparison of bonds with differing credit and liquidity risks against an interbank lending benchmark. Issuers often use the Libor spread to determine the relative cost of fixed-rate bonds versus floating-rate alternatives, such as an FRN or commercial paper. Investors use the Libor spread as a measure of a bond’s credit risk. Whereas a standard interest rate swap involves an exchange of fixed for floating cash flows based on a floating index, an asset swap converts the periodic fixed coupon of a specific bond to a Libor plus or minus a spread. If the bond is priced close to par, this conversion approximates the price of a bond’s credit risk over the Libor index
74
Z-spreads
=static spread
*a problem with G and I is that they assume the spot yield curve flat.
the amount added to each spot rate(Zero rate for government zero bonds) to get the bond price
PV=PMT(1+z1+Z)1+PMT(1+z2+Z)2+⋯+PMT+FV(1+zN+Z)N
75
Option adjusted spread (OAS)
(Z-spread) - (option value in basis points per year)
*for a putable bond option value should be adde to Z-spread.
**the idea is that the spread over benchmark for a bond with a embedded option is partly because of the option value, so it should be adjusted. the OAS is the spread to the government spot rate curve that the bond would have if it was option free.
76
Capital gain/loss in bonds
unlike stocks, not every change in price is a gain/loss, if we are on the constant yield price trajectory the no capital gain/loss
*can happen by changes in YTM through time
77
Credit risk
Credit risk: risk of losses if borrower fails to pay interest or principal
* default risk: probability of default
* loss severity: amount or percentage of principal and interest lost if borrower defaults.
***credit ratings only deal with the probability of default
78
expected loss
default risk*loss severity
79
Recovery rate
1 - loss severity in %
80
Yield spread
(in basis points)
quoted relative to default risk-free bond of similar maturity
*wider spread --> lower price
***spreads reflect expected loss
81
Spread risk
(a credit related risk)
risk of spread widening
*credit migration (downgrade) risk: issuer becomes less creditworthy
*market liquidity risk: receive less than market value when selling bond
82
Seniority ranking
the systematic way(order) in which lenders are repaid in case of bankruptcy or liquidation.
first lien/mortgage > 2nd lien/mortgage
senior > junior > subordinated
secured > unsecured
....
*the outcome could be different due to intensive negotiations at the time of bankruptcy!
overall priority:
1. first mortgage or first lien
2. second or subsequent lien
3. senior secured debt
4. senior unsecured debt
5. senior subordinated debt
6. subordinated debt
7. junior subordinated debt
83
Credit rating
* Corporate family rating (CFR): issuer credit rating, applies to senior unsecured debt---
* Corporate credit rating (CCR): applies to specific debt issue, may be notched up or down from CFR
84
Components of credit analysis
1. Capacity: ability to pay on time and in full
2. Collateral: value of assets
3. Covenants: legal stipulations of bond issue
4. Character: management integrity
85
Waterfall structure
*tranches
When the higher tiered creditors have received all interest and principal payments in full, the next tier of creditors begins to receive interest and principal payments.
86
Excess spread
Remaining net interest payments from the underlying assets of an asset-backed security, after all payables and expenses are covered.
The excess spread can be deposited into a reserve account in order to enhance the credit of the asset-backed security, or it can be paid out to investors.
87
Overcollateralization
The process of posting more collateral than is needed to obtain or secure financing. Overcollateralization is often used as a method of credit enhancement by lowering the creditor's exposure to default risk.
88
Surety bond
A surety bond is defined as a contract among at least three parties: the obligee - the party who is the recipient of an obligation. the principal - the primary party who will perform the contractual obligation. the surety - who assures the obligee that the principal can perform the task.
89
Cash collateral account
Cash Collateral Account is a Bank account in the name of a borrower that serves to secure and service a loan. While cash and check deposits are made into this account, it is considered essentially a zero-balance account and it cannot be drawn upon like a checking account. With a cash collateral account, money is deposited in a lockbox account; when the funds are collected and the deposits have cleared, the debt served by the account is reduced.
90
Sinking fund
A means of repaying funds that were borrowed through a bond issue. The issuer makes periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market.
91
OID tax provision
The purpose of an original issue discount tax provision is to tax investors in Company B’s bonds the same way as investors in Company A’s bonds. Thus, a prorated portion of the Z851.36 original issue discount is included in taxable income every tax year until maturity. This allows investors in Company B’s bonds to increase their cost basis in the bonds so that at maturity, they face no capital gain or loss.
92
Money market instruments
They range in time-to-maturity from overnight sale and repurchase agreements (repos) to one-year bank certificates of deposit. Money market instruments also include commercial paper, government issues of less than one year, bankers’ acceptances, and time deposits based on such indices as Libor and Euribor.
93
Quoted money market rates
1. discount rate: DR=(Year/Days)×[(FV−PV)/FV)]
2. add on interest: AOR=(Year/Days)×([FV−PV)/PV)]
both can be based on a 360 or 365 days year.
94
Secured vs unsecured bonds
bonds are secured if they are backed by specific collateral or unsecured if they represent an overall claim against the issuer's cash flows and assets
95
Capital depreciation tax
tax authorities typically treat the increase in value of a pure discount bond toward par as interest income to the bondholder, usually this interest income is taxed periodically during the life of the bond even though the bond holder does not receive any cash until maturity.
96
On the run sovereign bond
= benchmark sovereign bond
a sovereign bond that represents the most recent issue in a specific maturity.
97
Price sensitivity to changes in YTM
more sensitive when:
1. lower coupon rates (convexity)
2. longer maturities
98
No arbitrage price of a bond
sum of discounted coupons using spot rates :|
99
Accrued interest between coupon dates
*for full price model
=coupon payment*portion of the coupon period from last payment passed
*****we use this to calculate flat price from full price, full price = price at last coupon payment * (!+YTM)^ percentage of days between two payments passed.
* *determining the period of accrued interest:
1. actual days (for government bonds)
2. 30 day months or 360 day years (for corporate bonds)
* **in calculating full price we use actual days (?)
100
Effective yield of a bond
not equal to YTM, depends on its periodicity, for an annual bon it's equal to YTM
101
Matrix pricing 2- pricing newly issue bonds based on a benchmark
we should estimate the yield spread over the benchmark yield for newly issued bond:
```
5 year government: 1.48
5 year corporate AA: 2.64
7 year government: 2.15
7 year corporate AA: 3.55
6 year government: 1.74
6 year corporate AA:?
```
--> yield spread for 6 year bond estimation:
5 year: 1.16
7 year: 1.4
--> 6 year: (1.16 + 1.4) / 2 = 1.28 (interpolation)
--> 6 year corporate AA: 3.02
102
LIBOR quoting rules
*LIBOR quotes are nominal rates based on a 360 days year
30 days LIBOR = 3.6% --> 30 days effective rate = 3.6%/12
103
Pricing a floating rate note on a reset date
in a simplified pricing model, all future coupon payments are based on the reference rate on reset date plus quoted margin and then discounted using this reference rate and the required margin.
*LIBOR, quoted margin and required margin are all quoted on a nominal annual basis, so coupon rate= (LIBOR + quoted margin)/2 and discount rate= (LIBOR + required margin)/2 (for a semiannual FRN and 180 days LIBOR)
104
Calculate effective money market yields
*money market yields can be quoted in several ways (add on, discount, 360, 365) and all of them are quoted as simple annual interest, so in order compare two different money market instruments, we should calculate their effective yield given the knowledge of how the quoted yield was calculated. (quote model is given by the question)
105
Yield spread analysis
are useful for analyzing the factors that affect a bond's yield increases. if there is an increase but the spread is constant it means a change in macroeconomic factors has changed the overall rates, but an increase in the yield which is also in the yield spread mens a change in micro economic factors like credit risk and liquidity issues.
106
Par bond yield curev
is not calculated from yields on actual bonds but is constructed from the spot curve. the yields reflect the coupon rate that a hypothetical bond at each maturity would need to have to be priced at par.
** we have different spot rates and we have the price (par) and we want to calculate the coupon rate that would make it work! (coupon rate affects C)
107
Securitization
a process by which financial assets like mortgages, accounts receivable or automobile loans are purchased by an entity that then issues securities supported by the cash flows from those financial assets.
108
Securitization benefits
1. reduces intermediation costs, which results in lower funding costs for firms selling the financial assets to the securitizing entry (borrowers) and higher risk adjusted returns for lenders (investors)
2. investor's legal claim to the base financial assets is stronger than it is with a general claim against a company's or bank's overall assets. (**SPV i a separate legal entity and the buyers of the ABS have no claim against assets of the issuer of the underlying assets)
3. increases the liquidity of underlying financial assets.
4. allows investors to invest in securities that might better match their preferred risk, maturity and return characteristics.
5. provides diversification and risk reduction compared to purchasing individual loans.
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Securitization process
1. the seller originates loans (e.g., car loans) and sells the portfolio of loans to a SPV
2. the issuer (the trust) is the SPV that buys the loans from the seller and issues ABS to investors.
3. the servicer (here also seller, but not always) services the loans
* issuer often issues several classes of ABS each with different priority claims to the cash flows from the underlying assets (waterfall/tranche structure)
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Loan servicer
collects principal and interest payments, sends out delinquency notices, ...
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Residential mortgage loan
a loan for which the collateral that underlies the loan is residential real estate
* loan to value (LTV) ratio: the percentage of the value of the collateral real estate that is loaned to the borrower, the lower the LTV the higher the borrower's equity in the property
* less LTV means less risk because the borrower has more to lose in the event of default.
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Key characteristics of mortgage loans
1. maturity: in US typically between 15 to 30
2. interest rate: fixed rate mortgage or adjustable rate mortgage (ARM)- ARM can change over the life of the mortgage-- can be index reference (using LIBOR or ...)-- can be fixed for an initial period and then variable (hybrid mortgage)-- if a fixed rate changes to a different fixed rate after a period it's a rollover or renegotiable mortgage-- convertible mortgage: the initial interest rate terms can be changed at the option of the borrower.
3. Prepayment provisions: does it have a penalty or not? (prepayment is a partial or full repayment of principal in excess of the scheduled principal repayments)
4. foreclosure: non recourse loans (no claim against the assets of the borrower except for the collateral property itself-- recourse loan (have claims on other assets if the collateral is not sufficient)
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Agency residential mortgage backed securities
*agency RMBS: issued by government or government backed agencies, Ginnie Mae: highest credit, Fannie Mae and Freddie Mac are also of high credit
* are "mortgage pass through securities",
* WAM
* WAC
* WAL
* conforming loans vs non conforming loans
* pass through rate
* prepayment risk
* extension risk
* contraction risk
* single monthly mortality rate (SMM)
* conditional prepayment rate (CPR)
* public securities association (PSA) prepayment benchmark
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Non agency RMBS
* credit risk is an important consideration
* credit quality depends on the borrowers (all firms issuing the assets in the pool) and the characteristics of the loans like their LTV --> issuers usually use credit enhancement. --> internal and external credit enhancement:
1. external: using a moonlike insurance company
2. internal: reserve funds/ overcollaterlization/ senior (subordinated) structure, using tranches
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Reserve funds
1. cash reserve funds: cash deposits that come from issuance proceeds. this excess cash is used to establish a reserve account to pay for future credit losses.
2. excess servicing spread funds: reserve funds in the form of an extra return on the collateral mortgages above that required to make payments and servicing costs.
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Senior/subordinated structure
absorbs losses.
collateral value: 450,000
senior tranche: 300,000
subordinated tranche A: 80,000
subordinated tranche B: 30,000
--> losses up to 40,000 will be absorbed by over collateralization, nest 30 by B and next 80 by A
*shifting interest mechanism: if prepayments or defaults occur, credit losses decrease the credit enhance meant of the senior tranche, the shifting interest mechanism suspends payments to the subordinated tranches for a period of time until the credit quality of the senior tranche is restored.
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Collateralized mortgage obligations (CMO)
securities backed by mortgage pass through securities that securities secured by other securities!! securities that are collateralized by RMBS. each CMO has multiple bond classes (CMO tranches) that have different exposures to prepayment risk.
**this way cash flows generated by RMBS are distributed into different risk packages to better match investor preferences. (each CMO tranche has a different mixture of contraction and extension risk)
types:
1. sequential pay CMO
2. planned amortization class (PAC) CMO
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Commercial mortgage backed securities (CMBS)
backed by income producing real estate like apartments, warehouses, shopping centers, ...
*CMBS mortgages are structured as non recourse loans, so credit risk of the property is more important than the borrower--> assessing credit risk of property:
1. debt to service coverage ratio (DSC):
=net operating income/debt service (payments)
NOI: operating income minus only real estate taxes.
this ratio the higher the better
2. Loan to value ratio:
=current mortgage amount/ current appraised value
the lower the better (more cushioning)
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Non mortgage asset backed securities
1. auto loans ABS: fully amortizing- usually have internal credit enhancement- cash flow components from them include interest, principal and prepayment
2. credit card ABS: non amortizing-- so no principal payment to the holders during the lockout period, even if underlying credit card holders make principal payments during the lockout period, these payments are used to purchase additional credit card receivables, keeping the overall value of the pool constant
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Sequential pay CMO
The rule for the monthly distribution of the principal repayments (scheduled principal repayment plus prepayments) to the tranches in this structure is as follows. First, distribute all principal payments to Tranche 1 until the principal balance for Tranche 1 is zero. After Tranche 1 is paid off, distribute all principal payments to Tranche 2 until the principal balance for Tranche 2 is zero. After Tranche 2 is paid off, then do the same for Tranche 3, and so on.
*Interest distribution doesn't change.
*contraction and extension risk still exists with this structure but they have been redistributed to some extent between the two tranches. the short tranche offers more protection against extension risk and the other tranche offers more protection against contraction.
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Planned amortization class (PAC) CMO
has one or more PAC tranches and support tranches. a PAC tranche is structured to make predictable payments, regardless of actual prepayments to the underlying MBS, so PAC tranches reduce bot extension and contraction risk.
support tranches absorb (faster prepayments) or provide (slower prepayments) all the changes from scheduled repayments. so the larger the support tranches, the smaller the risk of out of schedule payments to PAC tranches.
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Initial PAC collar
the upper and lower bounds on the actual prepayment rates for which the support tranches are sufficient to provide or absorb actual prepayments and keep the PAC principal repayments on schedule.
* initial collar: 100-300 PSA --> scheduled principal payments hold if prepayments are between 100-300 PSA, otherwise not--> broken PAC
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CMBS structure
different structures for credit needs. each CMBS is segregated into tranches, losses due to default are first absorbed by the tranche with the lowest priority.
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CMBS call protection
call protection in CMBS is equivalent to prepayment protection. CMBS provide call protection in two ways:
1. loan level call protection: restrictions on prepayment.
2. CMBS level call protection: making tranches with specific sequence of repayment.
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CMBS balloon risk
*also referred to as extension risk because it entails extending the term of the loan
commercial mortgages are typically amortized over a period longer than the loan term (partial amortization) so at the end of the loan term the loan will still have principal outstanding that needs to be paid (balloon payment). if the borrower is unable to make this payment (balloon risk) the term should be extended to a workout period.
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Collateralized debt obligation (CDO)
* are "mortgage pass through securities",
* WAM
* WAC
* WAL
* conforming loans vs non conforming loans
* pass through rate
* prepayment risk
* extension risk
* contraction risk
* single monthly mortality rate (SMM)
* conditional prepayment rate (CPR)
* public securities association (PSA) prepayment benchmark
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WAM
Weighted average maturity
=weighted average of all the final maturities of all the mortgages in the pool, weighted by each mortgages outstanding principal balance as a proportion of the total outstanding principal value of all the mortgages in the pool.
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WAC
Weighted average coupon
=the weighted average of the interest rates of all the mortgages in the pool (weighted by outstanding principal proportion of all)
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Agency RMBS loans
there are some criteria needed to be met before adding a loan into agency RMBS pool, like size, LTV ratio, down payment percentage, ...
based on these there are conforming loans and non conforming loans. non conforming mortgages can be securitized by private companies for non agency RMBS.
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Prepayment risk
prepayments cause the timing and amount of cash flows from mortgage loans and MBS to be uncertain. mortgage loans used as a collateral for AGENCY RMBS have no prepayment PENALTY, so there could be great risk regarding changes in the scheduled payments.
* extension risk: the risk that prepayments will be slower than expected
* contraction risk: the opposite
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SMM
single monthly mortality rate
= the percentage by which prepayments reduce the month end principal balance, compared to what it would have been with only scheduled principal payments (no prepayments)
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CPR
conditional prepayment rate
| =an annualized measure of prepayments.
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PSA
public securities association (PSA) prepayment benchmark.
assumes that the monthly prepayment rate for a mortgage pool increases as it ages. the PSA benchmark is expressed as a monthly series of CPRs. if prepayment rate (CPR) of an MBS is expected to be the same as the PSA standard benchmark CPR, we say the PSA is 100 (100% of the benchmark CPR).
50--> prepayments slower than PSA 100-- 50% of PSA benchmark CPR
130--> faster, ....
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WAL
weighted average life
*based on an assumption about the prepayment rate for an MBS, we calculate it's WAL, or simply average life, which is the expected number of years until all the loan principal is repaid.
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YTM rising before first coupon payment- investor holds till maturity
everything the same- only reinvestment rate has increased--> greater rate of return than the YTM at purchase (and below the new YTM)
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YTM rising before first coupon payment- investor holds less than maturity
--> capital depreciation at sales + more reinvestment gain
- ->> *short investment horizon: market price risk> reinvestment risk so lower YTM
* long term investment horizon: reinvestment risk> market price risk.
* if investment horizon = macula duration --> capital depreciation and reinvestment gain approximately offset each other
e.g., if it's sold before any coupon payments or at the first payment there is no gain from the higher reinvestment rate, so investor's YTM will obviously decrease.
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Macaulay duration
Weighted average of the number of years until each payment.
*weights: PV of each payment as a percentage of the PV of all payments.
*periods: payment periods, not necessarily annual
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Modified duration
MacDur/(1+YTM)
*provides an approximate percentage change in a bond's price for a 1% change in YTM
--> approximate percentage change in bond price = -ModDur*[DELTA]YTM
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Approximate modified duration
= [(V-)-(V+)] / 2*V0*delta YTM
V- : price if YTM drops
V+ : price if YTM goes up by the same amount.
delta YTM: percentage change in YTM in decimals. (only the change in one way)
*it's a linear estimation, due to the convexity the real change in price by a change in YTM would be less for positive movement and more for negative movement.
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Effective duration
*useful for bonds that there's not absolute certainty in the future cash flows and timings, like bonds with embedded options like callable and puttable, also mortgage backed bonds (for prepayment option which is equal to being callable). --> we should use the benchmark yield curve.
=[(V-)-(V+)] / 2*V0*delta curve
V- and V+ --> prices using a bond pricing model and the change in the yield from the curve
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Key rate duration
=partial duration
duration is an adequate measure of bond price risk only for parallel shifts in the yield curve, the effect of non parallel shifts can be measure using key rate duration.
is the sensitivity of the value of a bond to changes in the spot rate for a specific maturity, holding other spot rates constant.
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Factors affecting a bond's interest rate risk
1. maturity--> longer: more risk
2. coupon rate: more--> less risk
3. YTM: more--> less risk
4. adding a call provision: value of the call increases as yields fall, so a decrease in the rate would have less effect on the price.
5. putable option: option to sell the bond back reduces the negative impact of yield increases on prices.
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Portfolio duration
1. weighted average number of periods until the portfolios cash flows will be received. (captures the IRR yield of the portfolio, not consistent with capturing he relationship between YTM and the price- also not usable for portfolios including bonds with embedded options)
2. weighted average of the durations of the individual bonds in the portfolio (weights are FULL price of the bond divided by the full price of the portfolio- for embedded options their effective value is used)--> usually this approach is used.
* one limitation is that for this approach to be meaningful the YTM of every bond in the portfolio must change by the same amount.
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Money duration
= dollar duration
=annual modified duration*full price of bond position.
money duration per 100 units of par value=
annual modified duration*full bond price per 100 of par value
***obviously money duration times change in YTM(as decimal) equals the change in bond value for that change in YTM.
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Price value of a basis point (PVBP)
the money change in the full price of a bond when it's YTM changes by one basis point.
direct calculation:
average of the decrease in the full value of a bond when YTM increases 1 bp and the increase of the value when YTM decreases 1 bp.
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Approximate convexity
| Effective convexity
1. (V-) + (V+) -2V0 / (delta YTM)^2 * V0
2. (V-) + (V+) -2V0 / (delta curve)^2 * V0
convexity is a second order effect to duration to adjust the errors regarding convexity.
given a equal duration, differences in factors like maturity, coupon, ... affects convexity in a way similar to duration
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Convexity of a callable bond
can be negative at low yields because at low yields the call options becomes more valuable and the call price puts an effective limit on increases in bond value.
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Convexity of a putable bond
is greater than the convexity of an otherwise identical option free bond. at higher yields the put becomes more valuable so that the value of the potable bond falls less than that of an option free bond as yield decreases.
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Estimate percentage price change using both duration and convexity
change in full bond price (percentage change)=
-annual modified duration (deltaYTM)
+1/2 annual convexity (deltaYTM)^2
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Term structure of yield volatility
refers to the relation between the volatility of bond yields and their times to maturity.
**durration and convexity of measures of sensitivity to a given shift in yield but investors need the volatility of the bond's price, which has two components, duration and convexity + volatility of the bond's yield. --->> so it's possible for a short term bond to have more price volatility than a long term bond.
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Duration gap
macauly durarion - investment horizon
positive--> exposure to market price risk
negative--> exposure to reinvestment risk.
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How does a change in spread affect price?
change in spread is actually a change in the total YTM, so we can use duration and convexity like before
*change in spread means a change in credit or liquidity (maturity risk is in the benchmark yield)
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FFO
funds from operations
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Credit analysis ratios
* net pension liabilities and off balance sheet financing should be added to debt
* can also: write down goodwill from the balance sheet and reduce retained earnings by the same amount--> higher debt to equity ratio
