CAIA - 35 - Structured Products I: Fixed Income Derivatives and Asset Backed Securities

Question 1

There are 2 broad approaches to model the term structure of interest rates:

1.

2.

Answer 1

There are 2 broad approaches to model the term structure of interest rates:

1. Equilibrium
2. Arbitrage-free

Question 2

___ models for modeling the term structure for interest rates assume a process for short-term interest rates and then use that process to look at the expected path of future interest rates.

Answer 2

Equilibrium models for modeling the term structure for interest rates assume a process for short-term interest rates and then use that process to look at the expected path of future interest rates.

Question 3

___-___models for modeling future interest rates project future interest rates in such a way that they are consistent with the observed term structure.

Answer 3

Arbitrage-free models for modeling future interest rates project future interest rates in such a way that they are consistent with the observed term structure.

Question 4

___ term structure model is a single-factor model that assumes that the short-term interest rate drifts toward a specific long-term mean.

Answer 4

Vasicek’s term structure model is a single-factor model that assumes that the short-term interest rate drifts toward a specific long-term mean.

Question 5

Vasicek’s Model

Answer 5

Question 6

Yield to Maturity in Vasicek

Answer 6

Question 7

CIR Model (Equation)

Answer 7

Question 8

A criticism of the Vasicek model is that it assumes the ___ of changes in the interest rates is constant as the ___ of interest rate changes.

Answer 8

A criticism of the Vasicek model is that it assumes the volatility of changes in the interest rates is constant as the level of interest rate changes.

Question 9

Ho and Lee Model

Answer 9

Question 10

Conditional Prepayment Rate (CPR)

Answer 10

Question 11

Absolute Prepayment Speed (ABS)

Answer 11

Question 12

Single Monthly Mortality (SMM)

Answer 12

Question 13

The ___, ___and ___ model modified the Vasicek model so that the variance of the short-term rate is proportional to the rate itself.

Answer 13

The Cox, Ingersoll and Ross (CIR) model modified the Vasicek model so that the variance of the short-term rate is proportional to the rate itself.

Question 14

___-___models of the term structure generate bonds that do not allow for arbitrage opportunities.

Answer 14

Arbitrage-free models of the term structure generate bonds that do not allow for arbitrage opportunities.

Question 15

The ___ and ___model assumes that the short-term interest rate follows a normally distributed process, with a drift parameter selected so that the modeled interest rates fit the observed structure of interest rates.

Answer 15

The Ho and Lee model assumes that the short-term interest rate follows a normally distributed process, with a drift parameter selected so that the modeled interest rates fit the observed structure of interest rates.

Question 16

The key disadvantage of the Ho and Lee model are that it assumes a very simple ___ process for bond prices and it can produce ___interest rates.

Answer 16

The key disadvantage of the Ho and Lee model are that it assumes a very simple binomial process for bond prices and it can produce negative interest rates.

Question 17

An ___ ___ ___is an interest rate derivative in which one party pays the other party when a specified reference rate exceeds a specific cap rate.

Answer 17

An interest rate cap is an interest rate derivative in which one party pays the other party when a specified reference rate exceeds a specific cap rate.

Question 18

A ___ is an interest rate cap that is guaranteed for one specific date.

Answer 18

A caplet is an interest rate cap that is guaranteed for one specific date.

Question 19

A ___ is a series of caplets and its price equals the sum of the caplet prices.

Answer 19

A cap is a series of caplets and its price equals the sum of the caplet prices.

Question 20

An ___ ___ ___ is an interest rate derivative in which one party pays the other when a specified reference rate is below a floor rate.

Answer 20

An interest rate floor is an interest rate derivative in which one party pays the other when a specified reference rate is below a floor rate.

Question 21

A ___ is an interest rate floor guaranteed for one specific date.

Answer 21

A floorlet is an interest rate floor guaranteed for one specific date.

Question 22

A ___ is a series of floorlets and its price equals the sum of the floorlet prices.

Answer 22

A floor is a series of floorlets and its price equals the sum of the floorlet prices.

Question 23

Issuers of floating rate debt can buy interest rate ___ to hedge their exposure.

Answer 23

Issuers of floating rate debt can buy interest rate caps to hedge their exposure.

Question 24

Lenders of floating-rate debt can buy interest rate ___ to hedge their exposure.

Answer 24

Lenders of floating-rate debt can buy interest rate floors to hedge their exposure.

Question 25

Since caps and floors are not typically exchange-traded instruments, buyers of these derivatives are exposed to ___ risk.

Answer 25

Since caps and floors are not typically exchange-traded instruments, buyers of these derivatives are exposed to counterparty risk.

Question 26

___ ___are bonds that can be redeemed by the bond issuer before maturity by making a set payment to the investor in a designated period.

Answer 26

Callable bonds are bonds that can be redeemed by the bond issuer before maturity by making a set payment to the investor in a designated period.

Question 27

Bond pricing models should account not only for interest rate risk but also for ___ risk.

Answer 27

Bond pricing models should account not only for interest rate risk but also for credit risk.

Question 28

Ignoring counterparty risk, payers in vanilla swaps benefit from ___ rates and suffer when rates ___.

Answer 28

Ignoring counterparty risk, payers in vanilla swaps benefit from increased rates and suffer when rates decline.

Question 29

Ignoring counterparty risk, receivers in vanilla swaps benefit from ___ rates and suffer when rates ___.

Answer 29

Ignoring counterparty risk, receivers in vanilla swaps benefit from declining rates and suffer when rates increase.

Question 30

Pension funds can use ___ ___ ___ or ___-___ ___ to reduce their interest rate risk.

Answer 30

Pension funds can use interest rates swaps or long-term bonds to reduce their interest rate risk.

Question 31

The ___ ___ ___ is a graphical representation of the relationship between swap rates and the maturities of their contracts.

Answer 31

The swap rate curve is a graphical representation of the relationship between swap rates and the maturities of their contracts.

Question 32

Prepayment risk is fairly ___ for auto loan backed securities.

Answer 32

Prepayment risk is fairly low for auto loan backed securities.

Question 33

Prepayment for most ABSs is measured by the ___ ___ ___ .

Answer 33

Prepayment for most ABSs is measured by the conditional prepayment rate (CPR).

Question 34

Auto Loan Backed Securities prepayment risk is typically measured using the ___ ___ ___.

Answer 34

Auto Loan Backed Securities prepayment risk is typically measured using the absolute prepayment speed (ABS).

Question 35

___-___ loans mean that lenders can collect only the loan collateral.

Answer 35

Non-recourse loans mean that lenders can collect only the loan collateral.

Question 36

Credit card and auto loans are (recourse/non-recourse) loans

Answer 36

Credit card and auto loans are recourse loans

Question 37

A ___ ___ ___ is an ABS that is secured by and receives cash flows from a pool of credit card receivables.

Answer 37

A credit card receivable is an ABS that is secured by and receives cash flows from a pool of credit card receivables.