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Flashcards in Finance 3 Deck (50)
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1
Q

partial call

A

When callable bonds are called, it can be for the entire issue or for just a part of it. A partial call can
be done on a random basis, like picking numbers out of a hat.

2
Q

pro rata call

A

A pro rata call allows all holders to redeem a certain percentage of their holdings while with a random, partial call it could be anyone’s guess as to which bonds will be called by the issuer.

3
Q

Price based on a Make-Whole Premium

A

This structure incorporates various formulas that can be structured to develop the price. The
formula is structured to protect the yield the investor had been receiving on his bond.

4
Q

Price based on Schedule

A

This call provision bases its price on stated dates with the price decreasing as the bond nears
maturity.

5
Q

Prepayment

A

This form of redemption occurs in ABS and MBS securities. In this instance the investor could
receive additional principal payments before the maturity date. For example, a homeowner with a
mortgage payment of $500 a month could pay more than that amount, say $700 a month. This
additional $200 would constitute a prepayment of principal. If this were to happen in the payment of
a bond, the bond would be redeemed before maturity.

6
Q

Sinking Fund Provisions

A

This helps redeem and retire bonds. It requires an issuer to retire or pay for the retirement of a
specific portion of the issue at certain times. This helps reduce credit risk by having something in the
“kitty” each year as a protection against a default. It can be structured to retire the entire issue at
its maturity date or only a portion of the balance of the issue. If provision is only for a balance of the
issue, the final payment is paid by a balloon payment.

7
Q

Which options benefit the issuer?

A

call options, prepayment, caps

8
Q

Which options benefit the investor?

A

put options, floors, conversion privilege

9
Q

conversion privilege

A

This allows the bondholders to exchange their current bond with equity in the same firm using convertible bonds. They may also receive equity or fixed income securities in another firm by the use of exchangeable bonds. This benefits the holder because if the equity or other securities of the firm is outperforming the bonds, the bonds can be converted, allowing the holder to realize a higher return.

10
Q

buying on margin

A

In this form of financing the buyer borrows funds from a broker/dealer who in turn gets the cash from a bank. The institution is charged an interest rate plus some additional charges for using this method. Regulations T and U, as well as the Securities Act of 1934, limit the degree to which the margin can be extended to the buyer.

11
Q

repo rate

A

an implied interest rate, which is the cost that the institution incurs for funding the position. Its benefit is that it is a very cheap way to finance a position because the repo rate tends to be set around the Federal Funds rate.

12
Q

Repurchase agreements

A

These are collateralized loans in which the institution sells a security with the commitment to purchase the same security at a later date. The length of time could be as short as overnight or extend all the way to the maturity of the security. The price that is agreed upon is the repurchase price and the institution is charged a repo rate.

13
Q

interest rate risk (bonds)

A

Interest rate risk is concerned with a decline in the price of a bond or a portfolio of bonds due to an
increase in market rates. As rates increase, bond prices decline and vice versa.

14
Q

What does the length of maturity of a bond do to interest rate risk?

A

The longer the maturity of the bond, the more sensitive it is to interest rate movements. The reason for this effect is that more cash flows will be affected over a longer period of time.

15
Q

What effect would low coupon rates have on interest rate risk?

A

Lower coupon rates are more sensitive to interest rates. Why? If your bond is
paying 4% and rates are in an upward swing, the difference in the market yield and your yield
will continue to widen, which will push your bond values down.

16
Q

If interest rates decline, do call options become more valuable to the issuing company?

A

As interest rates decline the value of the option becomes more valuable to the issuing company. The price will increase as rates decline but will be held at the call or redemption price. This is because as rates decline it will become more likely that the issuer will call the bonds and that the holder will only receive the call price and not a true market price. Likewise, when rates rise the price will not drop as much because the option will maintain some sort of value when compared to a bond with no options.

17
Q

How are market yield volatility and interest rate risk related?

A

As market yield volatility increases, the interest rate risk increases. This is because there is a
greater chance of rates breaking out of their current ranges, either by rising or declining. Typically,
as rates increase there is a greater chance of this risk occurring because market prices of bonds will
decline as interest rates rise.

18
Q

What are three disadvantages of investing in bonds that are callable or prepayable?

A

difficult to develop and forecast cash flows; reinvestment risk; price compression

19
Q

What is price compression?

A

When rates decline there is a greater chance that the issuer will call the bonds. This compresses or holds the bond at its call price while bonds without this option will continue to increase in market value as rates continue to decrease.

20
Q

What is reinvestment risk?

A

As rates decrease and bond are called or prepaid,
investors will not be able to invest their proceeds at the old rates and will have to use new, lower
market rates to put their cash to work.

21
Q

What’s the reinvestment risk on zero-coupon bonds?

A

Zero coupon bonds have no reinvestment risk because there are no coupon payments made to the investor. Because of the lower coupon rate, however, zeros expose the investor to a higher interest rate risk.

22
Q

yield curve risk

A

The yield curve risk is how your portfolio will react with different exposures based on how the yield curve shifts. Because any measure of interest-rate risk assumes an equal amount of basis point moves on the yield curve, anything will be an approximation of how an investor’s portfolio will react. The risk involved here is the degree to which this approximation will not match of the actual yield curve movement.

23
Q

default risk

A

Default risk is the risk that the issuer will go belly up and not be able to pay its obligations of interest and principle. To help measure this risk, an investor can look at default rates. A default rate is the percentage of a population of bonds that are expected to default. Another ratio that an investor can look at is the recovery rate. This rate indicates how much and investor can expect to get back if a default occurs.

24
Q

credit spread risk

A

This second type of credit risk deals with how the spread of an issue over the treasury curve will react. For example, Ford five-year bonds may trade at 50 basis points above the current five-year treasury. If the five-year bond is trading at 3.5%, then the Ford bonds are trading at a yield of 4%. If this spread of 50 bps widens out compared to other bond issues, it would mean that the Ford bonds are not performing as well as the other bonds in the marketplace. Spreads tend to widen in poor performing economies.

25
Q

downgrade risk

A

The third type of credit risk deals with the rating agencies. These agencies, such as Moody’s, S&P and Fitch, give an issuer a rating or grade that indicates the possibility of default. On the more secure side, the ratings range from AAA, which is the best rating to AA, A, BBB. These are the ratings for investment-grade bonds. Once bonds dip into the BB, B, CCC ranges they become junk bonds or, in politically correct language, high yield securities. If one of these rating agencies downgrades a company’s rating, it may be harder for the corporation to pay. This will typically cause its marker value to decrease. That is what this risk is all about.

26
Q

What are the ratings for investment grade bonds?

A

AAA, AA, A, BBB

27
Q

When does a bond become a junk bond?

A

BB, B, CCC

28
Q

How is liquidity typically measured?

A

Liquidity is typically measured by the bid/ask spread. If the spread is wide, the market is illiquid. If the spread is narrow, the market is more liquid.

29
Q

What is liquidity risk?

A

Liquidity risk is concerned with an investor having to sell a bond below its indicated value, the indication having come from a recent transaction.

30
Q

mark-to-market

A

When the net asset value (NAV) of a mutual fund is valued based on the most current market valuation.

31
Q

Treasury Bills

A

Treasury bills have a maturity of less than 12 months, no coupon rate, are issued at a discount to par value, mature at par value and pay no coupon interest. The return the investor receives is the difference between the purchase price and the maturity price.

32
Q

Treasury notes

A

Treasury notes have a maturity of one to ten years. They have a coupon rate set by the market place at issue. They are issued approximately at par value and mature at par value.

33
Q

Treasury Bonds

A

Treasury bonds are the same as treasury notes except that they have maturities that are greater than ten years. The U.S. Government has not issued this type of bond for a while, but there are still some issues that are outstanding

34
Q

Treasury Inflation Protected Securities (TIPS)

A

TIPS are issued as notes or bonds and help to protect the investor against inflation risk. The example below illustrates how these securities work.

35
Q

What inflation index is used for TIPS?

A

The inflation index the government uses is the non-seasonally adjusted U.S. City Average All Item Consumer Price Index for All Urban Consumers (CPI-U)

36
Q

On-the-run securities

A

On-the-run securities are the most current security issued by the U.S.Treasury Department. These issues tend to be more liquid in the marketplace.

37
Q

Off-the-run securities

A

Off-the-run securities are the securities that are replaced by the on-the-run securities. These issues tend to be less liquid in the marketplace.

38
Q

Mortgage-backed security

A

An investment instrument that represents ownership of an undivided interest in a group of mortgages. Principal and interest from the individual mortgages are used to pay investors’ principal and interest on the MBS.

39
Q

Prepayment risk for MBS

A

The risk of prepayment is that they typically occur in declining rate environments. When this happens, individuals tend to refinance their mortgages or credit cards at lower rates, causing the securities that were made of these obligations to be prepaid before their stated maturity date. This causes the investors in these securities to have to reinvest their proceeds at a lower market rate.

40
Q

Ginnie Mae

A

Government National Mortgage Association

41
Q

What two forms of debt do GSEs issue?

A

GSEs issue two forms of debt: debentures are notes or bonds with typical maturities of one to 20 years, while discount notes are short-term papers with maturities ranging from overnight to 360 days.

42
Q

Mortgage pass through securities

A

Mortgage pass through securities are created when one or more bondholders form a pool (or collection) of mortgages and sell shares or certificates in the pool. The cash flows depend on the payments of the mortgage and opens the investor to prepayment risk. The monthly cash flows include net interest, scheduled principal payments and any principal prepayments

43
Q

Collateralized Mortgage Obligations (CMOs)

A

CMOs are a derivative securities. They help an investor pick the type of cash flows he wants to be exposed to based on how the pool of mortgages are sliced up into tranches. The tranches offer investors different payment rules and par values. For example Tranche A might receive all principal payments until the balance is zero then the payments would flow to Tranche B and so on.

44
Q

Why would you create a CMO?

A

The motivation behind creating a CMO is to spread the risk of prepayment among different classes of bonds. A CMO has several tranches that splits the mortgage pool into different layers. These layers have different par values and prepayment speeds. This aids investors in helping them manage the risk exposures they want in this arena.

45
Q

What are the four main factors that credit agencies look for?

A

character (conservative philosophy?), capacity (ability to pay obligations, collateral (assets pledged to secure the debt), covenants (limitations placed on the borrower’s activities)

46
Q

secured debt

A

Secured debt is a type of corporate bond that has some form of collateral, which is pledged to ensure that there is payment of the debt. The collateral can be either real property or personal property the bondholder has a lien against in case of default.

47
Q

unsecured debt

A

Unsecured debt is known as a debenture bond. It is the same as a secured bond only it doesn’t have the collateral pledge. The holders fall in the same range as general creditors if a default occurs. In case of default, secured debt is paid first, unsecured is paid second and if there is anything left, subordinated debenture bonds, or those held junior holders are finally paid.

48
Q

credit enhancements

A

Credit enhancements are a way to reduce risk for the bondholders. This entails another company guaranteeing their loans, typical through a third-party guarantee. This helps finance special projects for the parent company, which may finance at higher rates but still uses the parent company to guarantee the debt to reduce those funding costs.

49
Q

letters of credit (LOC)

A

Letters of Credit (LOC) are another form of enhancement. The LOC requires that the bank that issued the LOC make payments to the trustee when requested so that funds will be available for the issuer to make its payments. Even though this may reduce a layer of risk, the issuer and the firm that grants the LOC should be analyzed to ensure the bond is a solid investment.

50
Q

What is a structured note?

A

A synthetic medium-term debt obligation with embedded components and characteristics that adjust the risk/return profile of the security. A structured note is a hybrid security that attempts to change its profile by including additional modifying structures. A simple example would be a 5 year bond tied together with an option contract for increasing the returns. A motivation for their issuance is the fact that they allow investors to realize a profit from favorable price movements.