Theory 1st Part

Question 1

FI Instruments

Answer 1

Debt instruments such as loans and bonds that represent a contractual agreement. Not all liabilities are FI but all FI are liabilities

Question 2

A bond’s price & yield have

Answer 2

inverse relationship

Question 3

Indenture

Answer 3

Legal contract describing the features and other terms of a fixed - income security. Contain Covenants - Affirmative (specify what issuers are required to do. Pari passu clause, cross default clause) & Negative (What they shall not do). Affirmative covenants doesn’t impose additional cost on issuer nor materially constrain issuer’s discretion in operating its business. Usually investment grade bonds are unsecured & have only affirmative covenants

Question 4

Incurrence Test (Negative covenant)

Answer 4

Set of covenants which closely monitor certain financial ratios and restrict its ability to pay dividends to shareholders, repurchase shares, and / or take on additional debt unless tighter financial restrictions are met

Question 5

Floating Rate Note Coupon Rate

Answer 5

Market Reference Rate + Issuer specific spread. MRR changes but spread constant. Interest rate risk is less

Question 6

Credit linked notes

Answer 6

Most common with leveraged loans, or loans to issuers of lower credit quality. Coupon changes may also be linked to financial covenants or credit ratings

Question 7

Pari passu (equal footing) clause

Answer 7

ensures that a debt obligation is treated
the same as the borrower’s other senior debt instruments.

Question 8

Payment in Kind

Answer 8

Allow an issuer to pay periodic interest in the form of an increase in the bond or loan principal outstanding rather than as a cash
payment. Most frequently used by firms with relatively high reliance on debt financing and are usually associated with a higher interest rate to compensate investors assuming greater principal risk.

Question 9

Maturity vs Tenor

Answer 9

Date of final payment the issuer makes to investors vs The remaining time to maturity

Question 10

Perpetual Bond

Answer 10

Distinct from equities in that they have contractually defined cash flows, no voting rights, and greater seniority in the capital structure.

Question 11

Capital indexed bond vs Interest indexed bond

Answer 11

Principal amount is adjusted based on an inflation index, such as CPI or WPI. Interest is generally a fixed rate. When CPI falls, principal falls so int calculated on such principal also reduces vs Only the coupon is index linked and pays an inflation adjustment. These bonds are essentially an FRN in which the MRR is the rate of inflation. Interest-indexed bonds are more commonly issued by private financial intermediaries than by governments.

Question 12

Deferred coupon bonds

Answer 12

Pay no interest for the first few years and have a higher coupon paid later through maturity. Issuers seek to conserve cash immediately following the bond issue, which may indicate lower credit quality or that the issuer is financing a construction project that does not generate income until completion. Typically priced at a discount to par since the higher coupon is not usually sufficient to offset the forgone interest in earlier periods.

Question 13

Callable bond

Answer 13

Issuer has the right to recall at predetermined price. When YTM is higher than coupon rate issuer won’t recall. When YTM rises MP falls like a non-callable bond but when YTM falls MP rises but limited to call price. Investor expect high yield vs a similar non-callable bond due to uncertain maturity & limited price appreciation called call risk. A make-whole call is a contingency feature under which issuers can buy bonds back at a price usually based on the YTM of a sovereign bond of similar maturity plus a predetermined spread. These calls are rarely executed. Borrowers who believe their creditworthiness will improve frequently choose to issue callable debt, because the value of this contingency feature rises as a firm’s borrowing costs fall.

Question 14

Puttable Bond

Answer 14

Price of it is usually higher than otherwise non puttable bond. So yield is lower compared to others. Price won’t fall below put price but unlimited appreciation

Question 15

Convertible Bond

Answer 15

Price movement is linked to share price. When SP is below conversion price, bond acts like non convertible but when SP is well above conversion price, bond price closely track its conversion value. Issuer would have the lowest interest payments on a convertible bond. Yields on callable and puttable bonds are high compared to yields on convertibles. Issuer that would like to conserve near-term cash outflows would most likely issue due to low int payt

Question 16

Conversion ratio

Answer 16

Convertible bond par value / Conversion Price

Question 17

Conversion Value

Answer 17

Conversion Ratio x Current share price

Question 18

Warrant

Answer 18

attached option rather than an embedded one. Only call, put & convertible bond have embedded option

Question 19

Face Value

Answer 19

Amount an issuer agrees to repay to investors at maturity

Question 20

Current Yield

Answer 20

Annual Int / Bond Price

Question 21

YTM

Answer 21

IRR of bond equals YTM provided investor hold it till maturity, receives all payment as per schedule & reinvests it at YTM

Question 22

Yield Curve

Answer 22

Based on YTM & time to maturity. Mostly upward sloping coz investors demand more yield for bond with longer maturities. Bond with long maturities have high interest rate & high credit spread

Question 23

Standard bullet bond vs Amortizing bond

Answer 23

Full principal repayment at maturity (Investor face credit risk) vs early repayment of principal (Investor face reinvestment risk). Sinking fund & waterfall structure represent special case of amortizing bond. Balloon payment - Repays a portion of the principal each period, with a final lump sum
payment

Question 24

Sinking Fund vs Waterfall structure

Answer 24

Used by government and some corporate issuers vs ABS and MBS. Issuer plan to set aside funds over time in an escrow account to retire the bond early based on terms agreed upon issuance (For example, an issuer may direct the bond trustee to redeem a predetermined principal amount selected from among investors at random) vs Used to determine the timing of CF to investor classes with different priority claims to the same CF (Interest or coupon payments are paid to all classes with no preference, but the repayment of principal occurs sequentially so that the most senior investor class with the highest ranking in the capital structure receives principal payments first).

Question 25

OID Tax provision

Answer 25

Investor will recognize a prorated portion of the OID as taxable income each year and pay no capital gains tax upon maturity. Investor investing in bond without such provision pays CG at maturity

Question 26

Periodic Payment of fully amortizing loan

Answer 26

A = (r × Principal) / {1 − (1 + r) −N}. R - Int rate per period, N - No of payt period

Question 27

Periodic payment of partially amortizing loan with balloon payment

Answer 27

Find PV of balloon payment (Payt / (1+r)^n) where r - int rate per period & n - no of period. Deduct the PV of BP from principal. Use the above formula. (Page 30)

Question 28

Euro Bond

Answer 28

Issued in a currency different from the country where it's sold. Bonds issued and traded in this cross-border market & are usually named for currency in which they are denominated. Currency ≠ country of issue

Question 29

Global Bond

Answer 29

Bond issued simultaneously in the Eurobond market and in at least one domestic bond market, ensuring sufficient demand and access to all fixed-income investors regardless of location

Question 30

For all bonds

Answer 30

Currency in which a bond is denominated has a stronger effect on its price than where the bond is issued or traded. This is because market interest rates have a strong influence on a bond’s price, and the market interest rates that affect a bond are those associated with the currency in which the bond is denominated. Foreign, Euro & Global bonds are international bonds

Question 31

Bearer Bonds

Answer 31

Trustee didn't keep record of who own the bond. Only the clearing system knows. All bonds are now registered bonds

Question 32

Foreign Bond

Answer 32

Issued in a domestic market by a foreign issuer, in the domestic currency. Bonds sold in a country and denominated in that country’s currency by an entity from another country

Question 33

FI Instrument & mkt categorized based on

Answer 33

Issuer type (Sector), Credit Quality & Time to maturity

Question 34

FI Index vs Equity Index

Answer 34

More constituents securities, turnover & weighted by mkt value of debt o/s vs mkt cap. Broad equity index is easier to replicate compared to broad bond index

Question 35

Fallen angels

Answer 35

Formerly investment grade issuers whose credit quality has deteriorated since issuance. Bond have longer maturities compared to HY bonds, non callable with few restriction & covenant because these bonds were issued at the time when borrower was highly rated

Question 36

Intermediate term debt

Answer 36

Issued by corporates to meet working capital needs. Commercial paper for short term or seasonal working capital needs

Question 37

Bond fund aims to match return of specific index

Answer 37

hold a representative sample of constituent securities in order to match index returns because the complexity of bond indexes makes it impossible to purchase all the constituent

Question 38

Debut Bond issuer

Answer 38

New corporate legal entities formed after a merger, acquisition, or divestiture, which usually refinance all existing debt outstanding, Companies that reach a more mature stage of the life cycle with more predictable CF and begin issuing debt; and Sovereign governments that raise external foreign currency debt for the first time. Can offer either in public or private placement. Represent a private to public transition

Question 39

Reopening of existing bond

Answer 39

A less common strategy is to increase the size of an existing bond with a price significantly different from par

Question 40

Distressed debt

Answer 40

By the time an issuer’s debt has become distressed, its equity securities will likely have already been delisted.

Question 41

FI Issuance timeline

Answer 41

Secured bond issuance is usually a longer and more involved process than for unsecured investment-grade bonds.

Question 42

Investment Grade vs HY

Answer 42

Significant proportion of YTM attributed to govt benchmark yield vs issuer specific spread. Bond like CF vs Equity like CF. Importance to financial ratios & credit ratings to determine issuer's likelihood of default vs consider POD & LGD. Longer time to maturity vs Shorter time to maturity (10 yr or less)

Question 43

Revolving credit agrt (Revolver)

Answer 43

Most reliable source of short-term bank funding. Multiyear credit commitments in which lenders typically seek protections, such as covenants, which require or restrict certain borrower actions, as in the case of a bond indenture. Upfront cost in form of commitment fee not required unlike committed line

Question 44

Committed Line of credit (Regular)

Answer 44

More reliable than uncommitted. Unsecured & prepayable without penalty. Upfront cost in form of commitment fee on either the full or unused amount of line for committed period

Question 45

Uncommitted line of Credit

Answer 45

Less reliable form of bank borrowing. Charge MRR + Issuer specific spread on only principal o/s for period of use. Least costly. Offered on unsecured basis

Question 46

Repo vs long term debt & equity

Answer 46

Low cost vs Greater financial flexibility

Question 47

Repos

Answer 47

Short-term repos with high-quality collateral (lowest risk) result in the lowest return; however, investors can expect higher returns for longer repo terms and/or by accepting less liquid or lower quality collateral. Seller of security (Cash borrower) retains ownership as well as int paid by the security during repo term. Purpose - finance ownership of security, earn short term income by lending funds on secured basis & borrow a security to sell it short. When viewed from the perspective of the security buyer (cash lender), a repo transaction is sometimes referred to as a reverse repurchase agreement or reverse repo. Long term govt securities are the most common form of collateral due to high liquidity and safe

Question 48

Repo components

Answer 48

Initial Margin = Sec price (t0) / Purchase Price (t0) Haircut = Sec Price (0) - Purchase Price (0) / Security Price (0) Purchase price means amt that security seller gets. At end of repo term he shall pay repurchase price = Purchase price x (1+r) Variation margin = {Initial margin x Purchase price (t)} - Sec Price (t). Purchase price in variation margin calculation = Purchase price (0) x (1+r) where r is int from day 0 to day t. Use 360 days

Question 49

Repo rate

Answer 49

Increase with maturity, higher the demand for specific security lower the repo rate

Question 50

Triparty repo

Answer 50

Agents are involved. Agents don't change the credit risk but create cost efficiencies by providing access to larger collateral pool as well as specializing in valuation & safekeeping of assets. Agent responsible for cash, securities, collateral valuation & mgt as well as collateral custody

Question 51

Bridge financing vs Rollover risk

Answer 51

Interim financing until permanent financing are available vs possibility that issuer is unable to issue new paper at maturity (Use backup line of credit to minimize it)

Question 52

Certificate of Deposit

Answer 52

A non-negotiable CD involves payment of principal and interest at maturity to the initial depositor, with a penalty for early withdrawal. Negotiable CDs allow a depositor to withdraw funds by selling the CD in the open market prior to maturity.

Question 53

Interbank mkt

Answer 53

Involves short-term borrowing and lending among financial institutions on a secured or unsecured basis

Question 54

Central bank fund mkt

Answer 54

While some banks may have excess funds over the minimum reserve requirement, others may run short of required reserves. This imbalance is solved through the central bank funds market, allowing banks with a surplus of funds to lend to others. The interest rate at which central bank funds are bought (i.e., borrowed) and sold (i.e., lent) is known as the central bank funds rate. Bank can also borrow directly from central bank but collateral shall be used & int rate is higher than CBFR

Question 55

ABCP

Answer 55

This financing is not recorded on the balance sheet of the issuer. SPE (not the bank) issues ABCP to investors with a backup credit liquidity line provided by the bank. Investors purchase a liquid, short-term note from the SPE.

Question 56

Sovereign debt vs Corporate debt

Answer 56

Issuance managed by national treasury or finance ministry vs investment banks. Presence of investors in sovereign debt with varying non economic objectives

Question 57

Private issuers vs public sector

Answer 57

GAAP vs cash based rather than accrual

Question 58

Emerging Mkt sovereign debt

Answer 58

are often denominated in restricted domestic currency. Their external debt are denominated in both domestic & foreign currency

Question 59

Ricardian equivalence theorem

Answer 59

Govt's choice of debt maturity is irrelevant in determining the PV of FCF. Assumptions are Taxpayers smooth consumption over time by saving expected future taxes today for future payment, Taxpayers form rational expectations that today’s tax cuts will result in future tax increases, Capital markets are perfect with no transaction costs so taxpayers can freely borrow and lend & Taxpayers are altruistic on an intergenerational basis; that is, they pass on tax savings to descendants. Theory states that govt should fund themselves with the shortest possible maturity to minimize borrowing costs and avoid paying any term premium associated with longer-term interest rates. But excessive reliance on short term debt creates rollover risk, increasing variability of budget cost & tax rate.

Question 60

Non competitive bidder

Answer 60

Accepts price determined at auction & always receives securities

Question 61

Competitive Bid process

Answer 61

Single-price auction (All winning bidders pay the same price and receive the same coupon rate for the bonds regardless of their bid) Multiple-price auction (Different prices among bidders for the same bond issue). The single-price auction process may result in a lower cost of funds and broader distribution among investors, while multiple-price auctions may result in a narrower distribution of large bids because investors must accept bonds at their bid price. In single price auction all non-competitive bids are accepted while competitive bids are ranked starting at the lowest yield (highest bond price). The highest yield that fills the offering amount, counting from the bottom, is the “cut off.” Competitive bidders who bid higher than this yield (lower price) do not purchase any securities. Volatility in yield is reduced as all bidders receive same rate

Question 62

Primary dealers

Answer 62

Sovereign governments designate a group of financial intermediaries that are required to participate in all auctions with competitive prices, often serve as the central bank’s counterparty for open market operations and facilitate the purchase and sale of government debt by foreign central banks and other indirect bidders.

Question 63

On the run vs off the run sec

Answer 63

Most recently issued, used for benchmark yield, more liquid vs this. On the run bond trades at slightly lower YTM than off the run bond because of difference in demand for securities and cost of financing govt in repo mkt