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					     CFA LEVEL 1


STUDY SESSION 15 & 16


FIXED INCOME
                                     Rights and obligations
                                     Covenants          Negative                                                 a
       a. Bond's indenture
                                                        Affirmative


               Basic features of a bond
                                            Zero coupon
               Coupon rate structures
                                            Step-up notes
                                            Deferred coupon bonds
        b.                                  Coupon formula
               Floating-rate securities     Inverse floater
                                            Inflation-indexed bonds
                                            Caps and floors


                                  Full (dirty) price = Clean Price + Accrued interest
        c. Bond trades            Cum coupon
        between                   vs. Ex-coupon
        coupon dates              Trading flat


                                                          Nonamortizing/ Bullet
                                                          bond/ Bullet maturity


                                                          Amortizing securities


                                                          Prepayment options


61. Features                                              Call provisions
  Of Debt
 Securities
                      d. Provisions for                   Nonrefundable bonds
                      redemption and
                      retirement of bonds
                                                          Sinking fund provisions       Cash payment
                                                                                        Delivery of securities


                                                          Accelerated sinking
                                                          fund provision


                                                          Redemption price        Regular
                                                                                  Special


                                Security owner
                                (bondholders)           Conversion option
                                options
                                                        Put provision
                                                        Floors



        e. Embedded             Security issuer         Call provision
        options                 (borrowers)             Prepayment options
                                options
                                                        Accelerated sinking
                                                        fund provisions
                                                        Caps


                                                 Margin buying
        f. Methods to finance the
        purchase of a security                   Repo
                                Interest rate risk                                                                                a
                                Yield curve risk

                                Call risk

                                Prepayment risk

                                                                                            Coupon
                                                             i. Factors affecting           Call feature
                                Reinvestment risk
                                                             reinvestment risk              Amortizing
                                                                                            Prepayment option



                                                                       Default risk
                                Credit risk          j. Forms          Credit spread risk
        a,i,j,k,l,m,n,o.                                               Downgrade risk
        Risks                                        j. Meaning and role of credit rating


                                Liquidity risk         k. why important even hold to maturity


                                l. Exchange-rate risk

                                m. Inflation risk

                                n. Volatility risk

                                                       Disaster
                                o. Event risk
                                                       Corporate restructuring
                                                       Regulatory issues

                                Sovereign risk
  62. Risks
Associated                                            Coupon rate
    With                                              Market yield
Investing In
                           b. Relations               Bond's price relative           Discount
   Bonds                   among                      to par value
                                                                                      Premium
                                                                                      Equal to par


                                         Maturity
                                         Coupon

        c. Effect on interest            Embedded
                                         options                Call
        rate risk of
                                                                Put
                                         Yield


                                                      value of option-free bond
                                    Value =
                                                                 minus
                                                      value of embedded call

                                    h. Disadvantages of a
       d,h. Callable bond
                                    callable or prepayable                Less certain CF- call risk/prepayment risk
                                    security to investors
                                                                          Reinvestment risk
                                                                          Potential price appreciation < option free securities


                             Interest rate risk

        e. Floating
                             Reasons Price # Par             Cap risk
        rate security
                                                             Margin


                            Duration =


                            Dollar duration =
       f,g. Duration
                            g. Duration and Yield curve
                            risk for a portfolio of bonds
                                                    Features
                                                                                                                                                  a
                                                    Credit risk
                                                    characteristics

                         a. Government
                         securities                                    Regular cycle auction- single price
                         (sovereign debt)
                                                    Distribution       Regular cycle auction- multiple price
                                                    methods

                                                                       Ad hoc auction system

                                                                       Tap system


                                                                    T-bills
       TREASURIES
                                                                    T- notes
                                                 Instruments
                                                                    T- bonds

                                                                    TIPS


                         b,c. Treasury
                                                 Two categories
                         securities              (vintage)                On-the-run
                         (Treasuries)                                     Off-the-run


                                                 c. Stripped
                                                 Treasury           Coupon strips
                                                 securities
                                                                    Principal strips
                                                                    STRIPS

    63.1
  Overview
  Of Bond                                Federally related institutions
   Sectors                               (owned by US Gov.)                      Ginnie Mae (Government National Mortgage Association)
    And                                                                          TVA (Tennessee Valley Authority)
Instruments
                      d. Types           GSEs (Government Sponsored Enterprises)                Federal Farm Credit System
                      of US Fed          (privately owned, publicly chartered)                  Federal home Loan Bank System
                      agencies           (commonly issue debentures)
                                                                                                Federal National Mortgage Association (Fannie Mae)
                                                                                                Federal Home Loan Bank Corporation (Freddie Mac)
                                                                                                Student Loan Marketing Association (Sallie Mae)


                                  Debentures (unsecured, not backed by collateral)

                                                               Characteristics

                                                                       Periodic interest
                                                               CF
       AGENCY                                                          Scheduled repayments of principal
       BONDS                                                           Principal repayments in excess of scheduled principal payments


                                                                           Mortgage
                                                                           passthrough
                                                                           security
                    Instruments     e,f. MBS
                                    (Mortgage-
                                    backed                                                                           Tranche I
                                    securities)                                                       3 tranches
                                                                                                                     Tranche II
                                                               Types
                                                                           CMOs (Collateralized
                                                                                                                     Tranche III
                                                                           mortgage obligations)

                                                                                                      f. Motivation for creating CMO


                                                                           Stripped
                                                                           mortgage-backed
                                                                           securities
                              Tax exempt                                                                        a
                     Tax

                              Taxable



                                                                           Limited tax GO debt
                                                                           Unlimited tax GO debt
                                         Tax- backed bonds or GO
       g. MUNIS                          (General Obligation) bonds        Double-barreled bonds
       (Municipal                                                          Appropriation-backed obligations
       securities)                                                         (or Moral obligation bonds)
                     Instruments

                                         Revenue bonds

                                         Insured bonds

                                         Prerefunded bonds



                           Rating agencies and Credit ratings


                           Secured vs. Unsecured Debt


                           Credit enhancements


                                                            Shelf registration (sold over time)
                                             Medium
                                             term           Maturity ranges
                                             notes
                                                            Best effort underwriting

    63.2
  Overview                                                     = typical bond + derivative
  Of Bond                                                      Purpose: get around restrictions
   Sectors                                                                        Step-up notes
    And                                      Structured                           Inverse floaters
Instruments                                  notes             Structured         Deleveraged floaters
   (cont.)                                                     medium term
                                                               notes              Dual-indexed floaters
                                                                                  Range notes
                                                                                  Index amortizing notes


       h,i,j,k.            Instruments
                                             Commercial         Directly placed
       CORPORATE                             paper
       ISSUES
                                                                Dealer placed

                                             Negotiable CDs

                                             Bankers Acceptances

                                                                    Role of a SPV

                                             i. Asset-backed        Motivation
                                             securities
                                                                    External credit      Corporate guarantees
                                                                    enhancements
                                                                                         LC
                                                                                         Bond insurance

                                             j. CDO (Collateralized debt obligation)




                                           Primary        Mechanism for
                                           market         placing bonds
                           k. Bonds

                                           Secondary
                                           market
                                                 Discount rate         Banks borrow reserves from Fed
                                                                                                                      a

                                                 OMO         Buy/Sell Treasuries by Fed
                                                             Most commonly used
          a. Interest rate policy tools
                                                 Bank reserve requirement           % of deposits banks must retain

                                                 Persuading banks to tighten/loosen credit policies




                                              Normal / Upward

                                              Inverted / Downward
          b. Yield curve / Term
          structure of interest rate          Flat

                                              Humped




                                               Pure expectation


          c. Basic theories of term            Liquidity preference
          structure of interest rate
                                               Market segmentation theory




                           d. Define a spot rate
64. Understanding
   Yield Spread

                                                       Absolute yield spread =

                               e. Measures             Relative yield spread =

                                                       Yield ratio =



                                                                        = yield difference b/c of credit rating
                               f. Credit (quality) spread
                                                                        Relation with the well-being
          Yield spread                                                  of the economy


                               g. Effect of embedded options

                                                               Issue size
                               h. Liquidity spread


                               Maturity spread




                     After tax yield of a taxable security
          i. Tax     Tax equivalent yield of a tax-exempt security




          j. LIBOR
                                      1. Estimate CFs       Coupons
                                                            Principal
          a. Steps in bond                                                              a
                                      2. Determine appropriate discount rate
          valuation process
                                      3. Calculate present value




                                    Defaults and potential credit problems

                                    Embedded options -> uncertain principal repayment
          b. Difficulties in
          estimating CFs            Floating rate securities -> uncertain coupons

                                    Convertible or Exchangeable bonds




65. Introduction                    Compute value of bonds
     To The
                                    Change in Value when
 Valuation Of                  c.   interest rates change
Debt Securities
                                    Price-yield profile




         d. Time and value of bond




         e. Zero- coupon bond




          f. Arbitrage free
          valuation approach
                                       Coupons
       a. Sources of return            Principal + Capital gain/loss                                             a
       from investing in bond          Reinvestment income


                           Current yield


                                      d. Calculate BEY and EAY
                                                        CF will be reinvested at YTM
                                      Assumptions
                                                        Bond will be held till maturity

                                                                                   Reinvestment income
                           YTM

                                                       c. Reinvestment                              Higher
                                      Limitations                                  Reinvestment     coupons
                                                                                   risk increases
                                                                                   with             Longer
                                                                                                    maturities
                                                      Realized yield can be different from YTM
        b,c,d.
        Traditional
        yield              BEY
        measures

  66. Yield                Yield to call
 Measures,
 Spot Rates                Yield to worst
And Forward
   Rates
                           Yield to refunding


                           YTP


                           CFY


       e. Theoretical Treasury spot rate curve-
       BOOTSTRAPPING


                         Nominal spread



                         Zero-volatility spread (Z-spread)
      f,g. Spreads

                         Option-adjusted spread (OAS)          g. OAS = Z spread - Option cost



      h. Spot rates, Forward rates, Value of bonds
                                Full valuation approach
                                (scenario analysis)
          a. Measuring
          interest rate         Duration/ convexity approach                                     a



                                       Option-free bonds


                                       Callable bonds
          b. Price volatility
          characteristics for          Prepayable bonds


                                       Putable bonds




                                                                         d. Effective duration


                                                d,e,f. Types
                                                                         Macaulay duration
                                                of duration


                                                                         Modified duration
67. Introduction
     To The                 Duration           Interpreting duration
Measurement Of
 Interest Rate                                                                 =
       Risk                                     g. Portfolio duration
                                                                               Limitations



                                                                 =
                                                j. PVBP
                                                                 Relationship to duration




                                 What is it?


                                 Can be         Positive
                                                Negative


                                 Relation to bond price and yield
         c,h,i. Convexity

                                 h. Calculation


                                 i. Types        Modified convexity
                                                 Effective convexity




          k. Impact of yield volatility on i/r risk of bonds

				
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posted:8/22/2011
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