FI Flashcards
Riding the Yield Curve
When the yield curve is upward sloping, investors can hold longer term maturity bond than their investment horizon to earn excess return
The Swap Rate Curve
Benchmark measure of interest rates. Represents fixed-rate leg in an interest rate swap
Swap Spread = Swap Rate - Treasury Bond Yield
Z- Spread
Spread when added to each spot rate on yield curvemakes the PV of a bond’s CF = the bond’s market price
TED Spread
Amount LIBOR exceeds overnight indexed swap rate (OIS)
Measure of credit risk and indication of health of banking system
Unbiased Expectations Theory
Forward rates are an unbiased predictor of future spot rates
Local Expectations Theory
Preserves the risk-neutrality assumption only for short holding periods
Over short time periods, every bond should earn the risk-free rate
Liquidity Preference Theory
Investors demand liquidity premium that is positively related to a bond’s maturity
Segmented Markets Theory
The shape of the yield curve is the result of supply and demand of funds in different market segments
Preferred Habitat Theory
Market participants will deviate from their preferred maturity habitat if compensated adequately
2 types of modern term structure models
Equilibrium Term Structure Models (CIR and Vasicek)
Arbitrage-free models (Ho-Lee) - Begins w/ observed market prices and the assumption that securities are correctly priced
Cox-Ingersoll-Ross Model
Assumes the economy has a natural long-run interest rate (b) that the short-term rate (r) converges to
dr = a(b-r)dt + σ √(rdz)
Vasicek Model
Assumes interest rate volatility level is independant of the level of shor-term interest rates
dr = a(b-r)dt + σdz
Ho-Lee Model
drt = Φdt + σdzt
Effective Duration
Measures the sensitivity of a bond’s price ot parallel shifts in the benchmark yield curve
ED = [(BV-Δy) - (BV+Δy)] / [2 * BV0 * Δy]
Key Rate Duration
Measures bond price sensitivity to a change in a specific spot rate, keeping everything else constant
OAS spreads
The constant spread added to each forward rate in a benchmark binomial interest rate tree such that the sum of the PVs of a credit risky bond’s CF = its market price
Effective Duration Totalogies
ED (Callable/Puttable)
One sided durations (when rates rise vs. when they fall) ________ interest rate sensitivity than regular EDs for bonds w/ embedded options
better capture
When option is at/near the money callable (puttable) bonds will have _____ (____) one-sided ____ duration than one-sided ___ duration.
lower (higher) ; down ; up
Straight and putable bonds exhibit ____ convexity throughout
positive
Callable bonds exhibit ____ convexity when rates are _____, and ____ convexity when rates are ____
positive ; high ; negative ; lower
Conversion Value
Market price of stock * conversion ratio
Market Conversion Price
Market price of convertible bond / conversion ratio
Market Conversion Premium per Share
Market conversion price - market price
Present Value of expected loss
Difference btw value of credit-risk bond and identical risk-free bond
Structural Model
Corporate credit risk is base don the stricture of the company’s balance sheet
Value of Stock = Max [Assets - Face Vale of Debt, 0]
Value of Debt = Min [Face Value of Debt, Assets]
Reduced Form Model
Allows for flexibility and incorporation of real world conditions
Assumes >= 1 ZCB outstanding
rf rate, PD, and recovery rate vary w/ the state of the economy
Credit Spread is the difference btwn the yield on a zero-coupon ______ and a zero-coupon ____
Credit risk bond; risk-free bond
Unlike corporate debt, ABS….
… do not default; rather losses in ABS’s collateral pool are borne by different tranches of the ABS structure base on the distribution waterfall
The pure expectations theory assumes risk ______, that is, investors are _____ by uncertainty and risk ______ do not exist.
Neutrality; Unaffected; Premiums
In a structural model the holding the company’s equity is economically equivalent to owning _____ option on the company’s _______
European Call Option ; Assets
