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CFA L2 > Fixed Income > Flashcards

Fixed Income Flashcards

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1
Q

Chapter 32: Term Structure and Interest rate dynamics

Spot rate

A

rate of interest on an option-free, default-free, zero-coupon bond (gov’t bond/bill)

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2
Q

forward rate

A

interest rate set today for some future period

Forward rates are read as f(when, what)

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3
Q

Forward rate model

A

[1+S(j+k)](j+k) = (1+Sj)j x [1 + f(j,k)]k

This model illustrates how forward rates and spot rates are interrelated.

For example, f(2,3) should make investors indifferent between buying a 5-yr zero-coupon bond versus buying a 2-yr zero-coupon bond and at maturity, reinvesting the principal for 3 additional years

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4
Q

Forward pricing model

A
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5
Q

When the spot curve is upward sloping, the forward curve lies

A

above the spot curve

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6
Q

When the spot curve is downward sloping, the forward curve lies…

A

below spot curve

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7
Q

YTM vs spot rate

A

YTM is simply the weighted-average of spot rates used in valuation

YTM is a poor proxy for expected return

YTM works as expected return only if:

  • held to maturity
  • no default
  • coupon payments are reinvested at YTM
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8
Q

Par curve

A

YTM on coupon paying bonds (gov’t) priced at par

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9
Q

IF spot rates evolve as predicted by forward rates…

A

bonds of all maturities will realize a 1 period return = 1 period spot rate and the forward price would be the same

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10
Q

Active bond portfolio management is built on the assumption that..

A

current forward curve may not accurately predict future spot rates

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11
Q

IF implied forward rates are too high

A

buy bonds

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12
Q

if implied forward rates are too low

A

sell bonds

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13
Q

Riding the yield curve/rolling down the yield curve

A

buying bonds w/a maturity longer than the investment horizon would provide a total return > return on a maturity matching strategy.

The steeper the curve, longer the bond, greater the return

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14
Q

swap rates

A

price (in yield) that a fixed rate payer will pay for Libor

why use swap curve?

  • some countries don’t have a liquid gov’t bond market
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15
Q

swap spread

A

swap spread = swap rate - Treasury bond yield

swap spread is the additional interest rate paid by the fixed rate payer of an interest rate swap over the rate of the “on-the-run” gov’t bond of the same maturity

on the run = most recently issued

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16
Q

Z-spread

A

constant bps spread added to spot rates so that risky bond’s DCF = PV

Z-spread assumes interest rate volatility = 0

Can’t use this to value bonds w/embedded options

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17
Q

TED spread

A

TED spread = 3mo Libor rate - 3mo Tbill rate

TED spread is used as an indication of the overall level of credit risk in the economy

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18
Q

LIBOR-OIS spread

A

Libor rate - overnight indexed swap

This is an indicator of risk and liquidity of money market securities

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19
Q

Pure expectations theory (also know as unbiased expectations theory)

A

Forward curve is an unbiased predictor of future spot rates

Curve reflects

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20
Q

Local expecatations theory

A

Bond maturity doesn’t influence returns for short-holding periods

21
Q

Liquidity preference theory

A

Investors demand a liquidity premium that is positively related to a bond’s maturity

22
Q

Segmented markets theory

A

The shape of the yield curve is the result of the interactions of supply and demand for funds in different markets

Market participants are unable or unwilling to invest in securities other than their segmented market

23
Q

Preferred habitat theory

A

Similar to segmented markets theory. Borrowers/lenders will have a preference for a segment, but will move to other segments if returns are compelling

24
Q

Effective duration

A

Measures the sensitivity of a bond’s price to parallel shifts in the benchmark yield curve

25
Q

Key rate duration

A

Measures bond price sensitivity to a change in a specific spot rate keeping everything else constant

26
Q

Chapter 33: Arbitrage-free valuation framework

Arbitrage

A

Arbitrage = riskless profit with 0 investment

27
Q

2 types of arbitrage:

Value additivity

Dominance

A

Value additivity: value of the whole = value of the parts

Dominance:

A -> costing $100 and returning $105

B -> costing $200 and returning $220

28
Q

Arbitrage free valuation

A

an approach to security valuation that arrives at a price that is arbitrage free

29
Q

Lattice Model

A
30
Q

Pathwise valuation approach

A

In the pathwise valuation approach, the value of the bond is simply the average of the values of the bond at each path.

For a n-period binomial tree, there are 2(n+1) possible paths

31
Q

Chapter 34: Valuation and Analysis of Bonds w/Embedded option

Embedded option

A

contingency provision that can be exercised by the:

  • holder - put option
  • issuer - call option

European option - exercised on single date

American option - exercised anytime

Bermuda option - exercised on several selected dates

32
Q

Value of option embedded in a callable or putable bond

A

Vcall = Vstraight bond - Vcallable bond

Vput = Vputable bond - Vstraight bond

33
Q

When interest rates increase, value of call option

A

decreases

Therefore, the value of a callable bond decreases

34
Q

When interest rate decreases, the value of the call option

A

increases

Therefore, the value of the callable bond increases

35
Q

When the interest rate decreases, the value of the put option

A

decreases

Thus, the value of the putable bond increases

36
Q

When the interest rate increases, the value of the put option

A

increases

Thus, the value of the putable bond decreases

37
Q

Opition adjusted spread (OAS)

A

A constant spread added to each forward rate in a benchmark binomial interest rate tree, such that the sum of the PV of the credit risky bond’s cash flow = market price

38
Q

Effective duration

A

Effective Duration = (BV-Δy - BV+Δy)/(2 x BV0 x Δy)

Δy = change in required yield, in decimal form

BV-Δy = estimated price if yield decreases by Δy

BV+Δy = estimated price if yield increases by Δy

BV0 = initial observed bond price

39
Q

Effective Convexity

A

Effective convexity = (BV-Δy - BV+Δy)/(2 x BV0 x Δy)

Δy = change in required yield, in decimal form

BV-Δy = estimated price if yield decreases by Δy

BV+Δy = estimated price if yield increases by Δy

BV0 = initial observed bond price

40
Q

effective duration of a callable bond is less than or equal to

A

effective duration of a straight bond

41
Q

effective duration of a putable bond is less than or equal to

A

effective duration of a straight bond

42
Q

One-sided duration

A

durations that apply only when interest rates rise

43
Q

Key rate durations (also known as partial durations)

A

Key rate durations capture the interest rate sensitivity of a bond to changes in yields of specific benchmark maturities

Key rate duration is used to ID interest rate risk from changes in the shape of yield curve

44
Q

Capped floater

A

Value of a capped floater = value of straight floater - value of the embedded cap

45
Q

floored floater

A

Value of floored floater = value of a straight floater + value of the embedded floor

46
Q

Conversion ratio

A

Conversion ratio is the # of common shares for which a convertible bond can be exchanged

47
Q

conversion value

A

conversion value of a convertible bond is the value of the # of common stock into which the bond can be converted

conversion value = market price of stock x conversion ratio

48
Q

market conversion price

A

market conversion price = market price of convertible bond / conversion ratio

49
Q

market conversion premium per share

A

market conversion premium per share = market conversion price - market price

CFA L2 (8 decks)

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