Fixed Income

Question 0

Shortcomings of the pure expectations theory

Answer 0

Ignores price risk and reinvestment risk

Question 1

Explain pure expectations theory

Answer 1

Forward rates are solely a function of expected future spot rates

• upward sloping yield curve indicates rising ST rates
• downward sloping yield curve indicates falling ST rates

Question 2

Explain liquidity preference theory

Answer 2

Forward rates reflect expectations of future spot rates plus a liquidity premium

• positively sloped yield curve&raquo_space; rates expected to be flat (or slightly down) but liquidity premium added or rates expected to rise

Question 3

Explain preferred habitats theory

Answer 3

Forward rates represent expected rates plus a premium based on supply and demand for funds at different maturities

Question 4

How to calculate annualized volatility

Answer 4

(daily standard dev)*SQRT(# of trading days)

Question 5

Calculate confidence interval for yield

Answer 5

Yield +/- standard deviation

Where standard deviation = (ann std dev) x (yield) x (# of std devs)

Question 6

What is Z spread?

Answer 6

Spread added to each spot rate to make the PV of the cash flows equal to the bond’s price

= OAS + option cost

Question 7

Value of a call option on a bond

Answer 7

Value of noncallable - value of callable

Question 8

Value of an embedded put option for a bond

Answer 8

Value of putable bond - value of nonputable bond

Question 9

Bonds with spreads larger than the required spread are considered ________

Answer 9

Undervalued/cheap

Question 10

Credit spreads include compensation for ___, ___, and ___

Answer 10

• credit risk, liquidity risk and option risk

- probability of default, LGD, time value of money and risk premium

Question 11

Increased stock volatility will ____ the value of a callable convertible bond

Answer 11

Increase because value of the call option on the stock increases

Question 12

Increase in interest rate volatility will ____ the value of the callable convertible bond

Answer 12

Reduce because the value of the call option on the bond increases

Question 13

Conditional prepayment rate (CPR)

Answer 13

Annual rate at which a mortgage pool balance is assumed to be prepaid during the life of the pool

Question 14

Single monthly mortality rate

Answer 14

1 - (1-CPR)^(1/12)

Question 15

PSA prepayment benchmarks for 100 PSA

Answer 15

First 30 months: (month*0.2%) per month

Months 30-360: 6% per month

Question 16

Estimated prepayment amount for any given month

Answer 16

SMM*(beg monthly mortgage balance - scheduled principal payment for the month)

Question 17

Z tranche or accrual tranche

Answer 17

Last tranche that does not receive current interest until the outstanding principal of the other tranches have been repaid

Question 18

Planned amortization class (PAC) CMO

Answer 18

Pays the lesser amount of the repayment schedule which is based on a lower prepayment rate and an upper rate of the initial PAC collar

Question 19

Support tranche

Answer 19

• Part of a PAC CMO to collect the excess principal payments or provide principal
• Higher average life variability

Question 20

Return impact of spread changes

Answer 20

(-duration x Δspread) + (0.5 x convexity x (Δspread)^2)

Question 21

Effective duration

Answer 21

(Pd - Pu)/(2 x P x Δyield)

Pd = price if rates went down
Pu = price if rates went up
P = current price

Question 22

Effective convexity

Answer 22

(Pd + Pu - 2 x P)/(2 x P x Δyield^2)

Pd = price if rates went down
Pu = price if rates went up
P = current price

Question 23

Expected loss

Answer 23

=PD*LGD

Question 24

Weakness of structural model

Answer 24

• assumes a firm’s assets can be traded in a frictionless market
• requires firm’s equity to be publicly traded and model to match market’s actual structure

Question 25

Reduced form models

Answer 25

Applies a constant PD for all of a firm’s liabilities but different loss rates

Question 26

PV of expected loss on a bond

Answer 26

Sum of PV of cash flows based on credit spread (spot rate of risky bond - spot rate of risk-free bond)

Question 27

Change in bond price

Answer 27

(-ED x Δyield x 100) + (EC x (Δyield)^2 x 100)