Asset (Quality) Securities

Question 1

What are the elements of an Investment Policy?

Answer 1

GRAILS, AR

Goals

Risk and performance measurement

Authorized Activities and Instruments

Internal Controls and Independent Review

Limits

Selecting Brokers/Dealers

Accounting and Taxation

Reporting

Question 2

What are factors affecting basis when valuing futures and forward contracts?

Answer 2

CEP V

Cost of carry

Economic factors

Perception of rate movements

Volatility of interest rates.

Principal risk is that Basis may change from the time the hedge is initiated until termination.

Question 3

How do you slot callable, fixed rate bonds on the CR?

Answer 3

Slotted at maturity, call option isn’t reflected

Slotted by call date when called

Question 4

How do you slot callable floating-debt securities?

Answer 4

Slotted according to the amount of time remaining until their next repricing date, or maturity, whichever is earlier

Floating rate securities (and loans) at their floor or ceiling are treated as fixed rate until the begin to float again. (slotted at maturity)

Question 5

What are some types of interest rate swaps?

Answer 5

FASB-A

Forward - hasn’t reached its effective date; allowed a bank to initiate a swap with a delayed start/ Based on forward interest rates

Amortizing - has a national amount that declines (amortizes) over the life of the agreement. May be used to hedge amortizing assets or replicate CFs of mortgages products.

Swaptions - combines an option and a swap. 1 party has the option to enter into an interest-rate swap or terminate an existing swap at some future date.

Basic - Counterparties exchange variable-rate CFs based on different market indices. used to reduce basis and yield curve risks.

Accreting - has a notional principal that increased over the life of the agreement and could be used to hedge the increasing IRR in a construction loan. (loan balances increases during the funding of a construction project).

Question 6

What are some active investment strategies?

Answer 6

In India You Buy Lots of Bright Yellow Curry

Interest Rate Expectations Strategy - consists of adjusting the Duration of the portfolio

Individual Security Selection Strategy - looking for outperformers

Yield Curve Strategy- Bullet portfolio (concentrated on 1 point on the Yield Curve); Laddered portfolio; Barbell portfolio.

Yield Spread Strategies - trying to profit from expected changes in spread b/t sectors of the bond market. Spread between top quality and lower quality bonds narrows as business conditions improve.

CF matching strategies - trying to match the CF requirements of liabilities with the CF from bonds.

Question 7

What are characteristics of a bullet, laddered, and barbell portfolio? (Yield curve strategy)

Answer 7

Bullet portfolio - concentrated on 1 point on the Yield Curve

Laddered portfolio - spreads instruments across the maturity spectrum. Equal percentages of the portfolio maturing at different segments on the YC.

Barbell portfolio - concentrates instruments at the short term and long term extremes of the maturity spectrum. Created when long term rates fall more (bond prices increase) than when short term rates rise (bond prices decreases). Ability to reinvest short term at higher rates.

Question 8

What is a derivative?

Answer 8

marked to market

G/L are recognized in current earnings

If certain criteria is met, banks may defer the recognition in income of gains and losses on derivatives instruments used for hedging until they recognize in income the effects of related changes on the items hedged.

Question 9

What IRR are created by using off-balance sheet derivatives?

Answer 9

BRO

Basis Risk

Re-pricing Risk

Option Risk

Question 10

The 7 investments risks are?

Answer 10

COSMILL

Credit Risk

Operational / Transactional Risk: inadequate controls or procedures; human error; system failure; fraud

Settlement Risk: possibility that 1 side delivers, but the counterparty isn’t able to perform

Market Risk: loss of value due to a variety of factors

Interconnection Risk: possibility of decline in the subject instrument’s value due to changes in something it’s connected to (interest rates, indices, or values of other instruments)

Legal Risk: possibility that legal action will preclude contractual performance

Liquidity Risk

Question 11

What is a CMO/REMIC and how it is slotted on the CR?

Answer 11

mortgage derivative securities consisting of several classes secured by mortgages pass thru securities or whole mortgage loans

Slotted in the CR based on their WAL, regardless of whether they/re fixed or floating

Question 12

What are some factors affecting price?

Answer 12

Put Rodney in the Vortex

Proximity of the underlying index to strike

Remaining term to maturity

Volatility of the underlying index.

Question 13

The 4 principal market risks are?

Answer 13

BIPY

Basis Risk: risk that different market indices won’t move in perfect or predictable correlation

IRR (primary source)

Price Risk: threat that a change in the price of a production input will adversely impact a producer who uses that input. Factors include weather conditions, economic conditions, and political developments; futures and forwards hedges are used to combat

Yield Curve Risk: same type of instrument, but different effect depending on its maturity; exposure to unanticipated changes in the shape or slope of the Yield Curve

Question 14

What are some passive investment strategies?

Answer 14

Indexing - seeking to mirror a particular market segment’s performance

Immunization/Duration Matching - Structuring the portfolio so that IRR characteristics (Macaulay Duration) match the liability stream; requires frequent calculation and rebalancing

Question 15

What is a forward contract?

Answer 15

same as a future contract, but different b/c they’re customizable and they’re bough and sold OTC.

Question 16

I/O Strip: what happens when rates decline?

Answer 16

IODD

Rates decline = Value decreases bc there are more prepayments and lower interest payments

Question 17

What kind of limits should be included in an investment policy?

Answer 17

MCL-AM

Market Risk

Credit Risk

Liquidity Risk

Asset Types

Maturities

Question 18

What are unsuitable investments activities?

Answer 18

GW AS REP

Gains trading - purchase and sale at a profit after a short holding period

When-Issued Securities Trading - Buying and selling of securities in the period between the announcement of an offering and the issuance and payment date of the securities. Bank acquires the security but sells it for a profit before having to take delivery and pay for it

Adjusted Trading - sale of a security to a broker above the prevailing rate, and the simultaneous purchase and booking of a different security. Dealer ensured a profit

Short Sale - sale of a security that the bank doesn’t own

Repositioning Repurchase Agreement - Dealer allows a bank that’s entered into a when-issued or pair-off trade that can’t be closed at a profit to hold its speculative position until it can be sold at a profit

Extended Settlement - Typical settlement periods: Agencies 1 day; Corporates/Munis: 3 days; MBS: 60 days

Pair-offs: bank commits to purchase a security, but before the settlement date the bank pair-offs the purchase with the sale of the same security

Question 19

Classification of securities through Uniform Agreement don’t apply to which securities?

Answer 19

private debt

equity holdings in SBIC

securities held in trading accounts

Question 20

What are some types of market risk/value modeling measures? (DG TV)

Answer 20

Delta - change in the value of the option resulting from a small change in the underlying instrument. Higher D = higher price sensitivities

Gamma - measures the rate of change in delta. Delta with higher Gamma will have a higher risk.

Theta - loss of a contract’s value due to the passage of time

Vega - measures the risk of gain or loss resulting from changes in volatility. Vega is always positive bc option values increase as volatility rises.

Question 21

What is a future contract?

Answer 21

A standardized financial contract traded on organized exchanges. Obligates the buyer to purchase an asset (or seller to sell an asset) at a predetermined future date and price.

Contracts are settled in cash before expiration.

More liquid than a forward contract.

Question 22

CMO Residuals- what is the effect when rates change?

Answer 22

Similar to IODD

rates decline = value declines

rates increase = value increases

Question 23

Total return of a bond consists of what?

Answer 23

CCR

Change in MV over the measurement period

Coupon received

Re-investment interest on the CFs received during the measurement period

Question 24

Convexity?

Option free investments have?

Embedded options have?

Answer 24

Option free = positive convexity (long the option)

Embedded options = negative convexity (short the option)

Question 25

What happens when 2 or more ratings list different credit ratings?

Answer 25

Base assessments on the more recently issued findings

Question 26

What is a deleveraged note?

Answer 26

Floating rate instrument with coupon payments based on a specific point on the YC.

Coupon rate will adjust by a fraction of the change in the underlying index

Attractive when rates are expected to remain stable or decrease

Question 27

What are factors included in valuing futures and forward contracts?

Answer 27

Prices react to changing market rates just like bonds (rising rates = lower prices)

Basis - the different between the cash (spot) price and price in future market.

Question 28

How do you classify a security:

Investment grade with temp impairment

Investment grade with OTTI

Answer 28

Investment Grade with temp impairment = no classification

Investment grade with OTTI = impairment is loss

Question 29

P/O Strip: what happens when rates decline?

Answer 29

PODI

Rates decline = value increases because CF received sooner

Question 30

What is a leveraged note?

Answer 30

Floating rate instrument with coupon payments based on a specific point on the YC

Coupon rate will adjust by a multiple of the change in the underlying index

Attractive when rates are expected to increase

Question 31

How do you classify a security:

Sub investment grade with temp impairment

Sub investment grade with OTTI

Answer 31

Sub investment grade with temp impairment = classify amortized cost as Sub

Sub investment grade with OTTI = classify fair value as Sub and the impairment is loss