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CFA level 2 Feb2022 > Fixed income > Flashcards

Fixed income Flashcards

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1
Q

Module 28.1, LOS 28.a

What are the conditions for expected return on a bond being equal to the yield?

A

1) HTM
2) All payments (coupon and principal) are made on time and in full.
3) All coupons are reinvested at the original YTM (mostly unrealistic due to the curve form)

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2
Q

Module 28.1, LOS 28.a

What is greater given timeline 0-j-k: forward rate for period j-k or spot rate for period 0-k?

A

Depends on the curve slope:

1) if upwardsloping - then forward rate is greater
2) if downwardsloping - then spot rate is greater

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3
Q

Module 28.1, LOS 28.a
The model that equates buying a long-maturity zero-coupon bond to entering into a forward contract to buy a zero-coupon bond that matures at the same time is known as:

A

Forward pricing model

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4
Q

Module 28.2, LOS 28.c
If investor expects that future spot rate will be lower than currently implied future spot rate, what should be the strategy?

A

Purchase bonds (at a presumably attractive price) because the market appears to be discounting future cash flows at “too high” of a discount rate

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5
Q

Module 28.2, LOS 28.d

What is maturity matching strategy?

A

Purchasing bonds that have a maturity equal to the investor’s investment horizon.
Profit earned - only coupon payments

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6
Q

Module 28.2, LOS 28.d

What is rolling down the yield curve strategy?

A

Purchase bonds with maturities longer than his investment horizon if yield curve is upword sloping.
Profit earned - difference in price over holding period due to higher future periods yield

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7
Q

Module 28.2, LOS 28.d

What is the risk of rolling down the yield curve strategy?

A

The risk of such a leveraged strategy is the possibility of an increase in spot rates

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8
Q

Module 28.3, LOS 28.e

Why market participants use swap rate curve?

A

1) Reflect the credit risk of commercial banks rather than of governments
2) Swap market is not regulated by any government -> swap rates in different countries are more comparable
3) Yield quotes at many maturities, unlike government bond yield curve

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9
Q

Module 28.3, LOS 28.e
Which discount rates would be preffered by:
1) retail banks?
2) wholesale banks?

A

1) retail banks - government spot curve

2) wholesale banks - swap curve

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10
Q

Module 28.4, LOS 28.f

What is swap spread?

A

Amount by which the swap rate exceeds the yield of a government bond with the same maturity

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11
Q

Module 28.4, LOS 28.f

What is the usual sign of swap spread and why?

A

Positive, reflecting the lower credit risk of governments compared to the credit risk of surveyed banks

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12
Q

Module 28.4, LOS 28.g

Which short-term rates spread reflect sredit and liquidity risk of a bond?

A

I-spread - amount by which the yield on the risky bond exceeds the swap rate for the same maturity

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13
Q

Module 28.4, LOS 28.h

What is zero-volatility spread?

A

Z-spread - spread that, when added to each spot rate on the default-free spot curve, makes the present value of a bond’s cash flows equal to the bond’s market price

Not appropriate to use to value bonds with embedded options

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14
Q

Module 28.4, LOS 28.h

What is TED spread?

A

TED spread - amount by which the interest rate on loans between banks (formally, 3M LIBOR) exceeds the interest rate on short-term U.S. government debt (3M T-bills)

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15
Q

Module 28.5, LOS 28.h

What are main yield curve shape theories? Which one explains almost any yield curve shape?

A

1) unbiased expectations theory
2) local expectations theory (doesn’t hold)
3) liquidity preference theory
4) segmented markets theory
5) preferred habitat theory - explains most shapes

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16
Q

Module 28.5, LOS 28.h

What are the main assumptions of unbiased expectations theory?

A

1) investors’ expectations determine the shape of the interest rate term structure
2) every maturity strategy has the same expected return over a given investment horizon -> risk neutrality

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17
Q

Module 28.5, LOS 28.h

How assumptions of local expectations theory are different from unbiased expectations theory?

A

Local expectations theory preserves the risk-neutrality assumption only for short holding periods:

1) over longer periods, risk premiums should exist
2) over short time periods, every bond (even long-maturity risky bonds) should earn the risk-free rate

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18
Q

Module 28.5, LOS 28.h

What are the main assumptions and implications of liquidity preference theory?

A

Assumption:
forward rates reflect investors’ expectations of future spot rates, plus a liquidity premium to compensate investors for exposure to interest rate risk

Implications:

1) positive-sloping curve - either rates expected to rise or stay flat/fall + liq. premium brining it up
2) negative-sloping curve - fall in rates expected

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19
Q

Module 28.5, LOS 28.h

What are the main assumptions of segmented markets theory?

A

1) yield at each maturity is determined independently of the yields at other maturities
2) shape of the yield curve is determined by the preferences of borrowers and lenders
3) various market participants only deal in securities of a particular maturity

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20
Q

Module 28.5, LOS 28.h

What are the main assumptions of preferred habitat theory?

A

1) orward rates represent expected future spot rates plus a premium
2) existence of an imbalance between the supply and demand for funds in a given maturity range will induce lenders and borrowers to shift to other maturities
3) borrowers require cost savings (i.e., lower yields) and lenders require a yield premium (i.e., higher yields) to move out of their preferred habitats

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21
Q

Module 28.6, LOS 28.i

What are the main measures of yield curve risk?

A

1) Effective duration (measures sensitivity to small parallel changes in yield curve which explains ~75% variation of the price)
2) Key rate duration (separately measures sensitivity to some rate point changes -> if summed together = effective duration)
3) Sensitivity to Parallel (level), Steepness, and Curvature Movements (decomposes sensitivity to parallel shifts, long-term up +short-term down, long and short term up + others unchanged)

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22
Q

Module 28.6, LOS 28.j

What does short and long term yield curve volatility represent?

A

1) long-maturity end is thought to be associated with uncertainty regarding the real economy and inflation
2) short-maturity end reflects risks regarding monetary policy (expansions -> increase st rates -> bearish flattening, recession -> reduce st rates -> bullish steepening)

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23
Q

Module 28.6, LOS 28.k

Which macro factors impact yield curve changes?

A

1) Major - Inflation (2/3 variation of short and intermediate-term), GDP (1/6), monetary policy (1/6)
2) Others - fiscal policy (restrictive decreases yields), supply of gov. bonds maturities, investors demand

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24
Q

Module 28.6, LOS 28.k

What is the bond risk premium?

A

Bond risk premium (term premium or duration premium) is the excess return (over the one-year risk-free rate) earned by investors for investing in long-term government bonds.

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25
Q

Module 29.1, LOS 29.b

What are the two types of arbitrage?

A

1) value additivity violation - the value of whole differs from the sum of the values of parts
2) dominance - one asset trades at a lower price than another asset with identical characteristics

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26
Q

Module 29.1, LOS 29.c

In a binomial interest rate tree what is the relation between 2 adjasent forward rates in the same period?

A

Adjacent forward rates (at the same period) are two standard deviations apart - i1,U = i1,L e2σ

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27
Q

Module 29.1, LOS 29.c

What is the binomial interest rate tree?

A

Lognormal random walk model with two properties: (1) higher volatility at higher rates and (2) non-negative interest rates

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28
Q

Module 29.1, LOS 29.e

What is the backward induction?

A

Backward induction refers to the process of valuing a bond using a binomial interest rate tree

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29
Q

Module 29.2, LOS 29.d

What are the key assumptions of reconstructing binomial tree interest rates?

A

1) The interest rate tree should generate arbitrage-free values for the benchmark security
2) adjacent forward rates (for the same period) are two standard deviations apart (calculated as e2σ)
3) middle forward rate in a period is approximately equal to the implied (from the benchmark spot rate curve) one-period forward rate for that period

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30
Q

Module 29.2, LOS 29.f

What is the main difference between valuing bond with zero-coupon rate and binomial tree?

A

Bonds with embeded options can only be measured with binomial tree (allows for rates flactuations)
Option-free bonds can be valued with both

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31
Q

Module 29.2, LOS 29.g

How pathwise valuation is performed?

A

1) For a binomial interest rate tree with n periods, there will be 2(n–1) unique paths
2) Pathwise valuation discounts cash flows one year at a time using one-year forward rates.
3) Pathwise valuation goes one path at a time. Then average PV is found

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32
Q

Module 29.2, LOS 29.h

In which situation Monte-Carlo is preferred over binomial tree?

A

When cash flows are path dependent

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33
Q

Module 29.2, LOS 29.h

What is the drift adjusted model?

A

Result of calibration process of adding (subtracting) a constant to all rates when the value obtained from the simulated paths is too high (too low) relative to market prices

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34
Q

Module 29.3, LOS 29.i

What are the two main types of term structure models?

A

1) Equilibrium term structure models - describe changes in the term structure through the use of fundamental economic variables that drive interest rates
2) Arbitrage-Free Models - assumption that bonds trading in the market are correctly priced, and the model is calibrated to value such bonds consistent with their market price

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35
Q

Module 29.3, LOS 29.i

Describe Cox-Ingersoll-Ross (CIR) model

A

1) (CIR) model is based on the idea that interest rate movements are driven by individuals choosing between consumption today versus investing and consuming at a later time
2) volatility increases with the interest rate
3) interest rates are mean reverting to some long-run value

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36
Q

Module 29.3, LOS 29.i

Describe Vasicek model

A

1) volatility is constant
2) interest rates are mean reverting to some long-run value
3) model does not force interest rates to be non negative

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37
Q

Module 29.3, LOS 29.i

Describe Ho-Lee model

A

1) Derived using the relative pricing concepts of the Black-Scholes model
2) calibrated by using market prices to find the time-dependent drift term θt
3) assumes constant volatility and produces a symmetrical (normal) distribution of future rates

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38
Q

Module 29.3, LOS 29.i

Describe Kalotay-Williams-Fabozzi (KWF) model

A

Same as Ho-Lee model but assumes lognormal distribution of future rates

1) Derived using the relative pricing concepts of the Black-Scholes model
2) calibrated by using market prices to find the time-dependent drift term θt
3) assumes constant volatility and produces a lognormal distribution of future rates

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39
Q

Module 29.3, LOS 29.i

Describe Gauss+ model

A

1) Multifactor model that incorporates short medium and long-term rates, where the long-term rate is designed to be mean reverting and depends on macroeconomic variables
2) short-term rate is devoid of a random component—consistent with the role of the central bank controlling the short-term rate

40
Q

Module 29.1, LOS 29.b

What stripping and reconstitution?

A

1) Reconstitution - if a portfolio of strips is trading for less than the price of an intact bond, one can purchase the strips, combine them, and sell them as a bond.
2) Stripping - if the bond is worth less than its component parts, one could purchase the bond, break it into a portfolio of strips, and sell those components

41
Q

Module 29.2, LOS 29.h

What increasing the number of paths generated in a Monte Carlo simulation does?

A

Increase the statistical accuracy of the estimate but does nothing for the fundamental accuracy of the estimated value which depends on the quality of model inputs

42
Q

Module 30.1, LOS 30.a

What are the major types of fixed income securities with embeded options?

A

1) Callable bonds - investor is short the call option
2) Putable bonds and extendible bonds - investor is long the put option
3) Estate put - value inversely related to investor’s life expectancy
4) Sinking fund bonds (sinkers) - require the issuer to set aside funds periodically to retire the bond, have several related issuer options (e.g., call provisions, acceleration provisions, and delivery options)

43
Q

Module 30.1, LOS 30.b

How values of straight bond, callable/putable bond and option are related?

A

1) Vcall = Vstraight − Vcallable

2) Vput = Vputable − Vstraight

44
Q 
Module 30.3, LOS 30.d
Describe how values of putable and callable options vary due to:
1) changes in volatility?
2) changes in interest rates?
3) changes in shape of yield curve?
A

1) Value of put and call options rises when volatility increases -> callable bond falls in price, puttable bond increases in price
2) Call option is inversely related to rates movement, put option - directly related
3) As yield curve flattens - value of put option declines, value of call option increases

45
Q

Module 30.4, LOS 30.g

What is OAS spread, how it is calculated?

A

A constant spread added to all one-period rates in the tree such that the calculated value equals the market price of the risky bond
OAS is calculated after the option risk has been removed

46
Q

Module 30.4, LOS 30.g

What OAS spread in comparison to peers indicate?

A

1) low OAS (relative to peers) - overvalued

2) highOAS (relative to peers) - undervalued

47
Q

Module 30.4, LOS 30.h

How volatility of rates assumed and OAS spread are related for callable and putable bonds?

A

1) higher volatility -> call value + -> callable value - -> OAS -
2) higher volatility -> put value + -> puttable value + -> OAS +

48
Q

Module 30.5, LOS 30.i

Which duration and convexity should be used for fixed assets with embeded options? Provide formulas

A

effective duration = (BV-Δy - BV+Δy)/(2BV0Δy)

effective convexity = (BV-Δy + BV+Δy - 2BV0)/(BV0Δy^2)

49
Q

Module 30.5, LOS 30.i

What are the steps to compute BV+Δy and BV-Δy for duration and convexity for bonds with embeded options?

A

1) Compute OAS for the issue using the current market price and the binomial model
2) impose a small parallel shift in the benchmark yield curve by an amount equal to +Δy
3) Build a new binomial interest rate tree using the new yield curve
4) Add the OAS from step 1 to each of the one-year rates in the interest rate tree to get a “modified” tree
5) Compute BV+Δy using this modified interest rate tree.
6) Repeat for BV-Δy

50
Q

Module 30.5, LOS 30.j
Specify the following relations:
1) Effective duration (callable) ? effective duration (straight).
2) Effective duration (putable) ? effective duration (straight).
3) Effective duration (zero-coupon) ≈ ?
4) Effective duration of fixed-rate coupon bond ?maturity of the bond
5) Effective duration of floater ≈ ?

A

1) Effective duration (callable) ≤ effective duration (straight).
2) Effective duration (putable) ≤ effective duration (straight).
3) Effective duration (zero-coupon) ≈ maturity of the bond.
4) Effective duration of fixed-rate coupon bond < maturity of the bond.
5) Effective duration of floater ≈ time (in years) to next reset.

51
Q

Module 30.5, LOS 30.j

Do changes in interest rate affect straight bond effective duration? callable(puttable) bond duration?

A

1) ED of straight bonds is relatively unaffected by changes in interest rates
2) An increase (decrease) in rates would decrease the effective duration of a putable (callable) bond.

52
Q

Module 30.6, LOS 30.k
When close to money, which side duration whould be higher for:
1) callable bond?
2) puttable bond?

A

1) callable bond close to money - up-side duration higher

2) puttable bond close to money - down-side duration higher

53
Q 
Module 30.6, LOS 30.k
For low coupon rate bond which maturity key rate duration is the highest for:
1) option-free bond?
2) callable bond?
3) puttable bond?
A

1) option-free bond - independent of coupon rate, maturity key rate duration
2) callable bond - maturity key rate duration
3) puttable bond - option maturity key rate duration

54
Q 
Module 30.6, LOS 30.k
For high coupon rate bond which maturity key rate duration is the highest for:
1) option-free bond?
2) callable bond?
3) puttable bond?
A

1) option-free bond - independent of coupon rate, maturity key rate duration
2) callable bond - option maturity key rate duration
3) puttable bond - maturity key rate duration

55
Q

Module 30.6, LOS 30.k

For low coupon rate bond what sign under-maturity key rate durations have?

A

Negative

56
Q

Module 30.6, LOS 30.k

For par rate bond what sign under-maturity key rate durations have?

A

None, it is zero

57
Q

Module 30.6, LOS 30.l

Compare effective convexities of callable, putable, and straight bonds

A

1) Straight and puttable - positive convexity

2) Callable - for high rates - positive convexity, when at-the money - negative convexity

58
Q

Module 30.8, LOS 30.n

What is hard and soft put option?

A

1) hard - redeemable for cash

2) soft - redeemable for cash, stock, subordinated debentures or combination at a choice of issuer

59
Q

Module 30.8, LOS 30.o

What is the minimum value of a convertible bond and why it should be like that?

A

minimum value of a convertible bond = max (straight value, conversion value)
This must be the case, or arbitrage opportunities would be possible. For example, if a convertible bond were to sell for less than its conversion value, it could be purchased, immediately converted into common stock, and the stock could be sold for more than the cost of the bond

60
Q

Module 30.8, LOS 30.o

What does convertible callable bond value consist of?

A

callable convertible bond value = straight value of bond + value of call option on stock − value of call option on bond

61
Q 
Module 30.8, LOS 30.q
What is the relation between return on stock and convertible bond when stock price:
1) fall?
2) rise?
3) is stable?
A

1) fall - convertible bond has downside protection floored at straight or conversion value - return on it is higher
2) rise - due to convertible bond premium it’s return is lower
3) is stable - return can be higher for convertible bond due to coupon payments

62
Q

Module 30.8, LOS 30.q

When convertible bond behaves as fixed income or as equity?

A

When P stock is very low, closer to straight bond - busted convertible
When P stock is very high - closer to equity

63
Q 
Module 31.1, LOS 31.a
How to compute:
1) 1st year PD?
2) t year PD?
3) t year LGD?
4) t year PS?
5) CVA?
6) t year expected loss?
A

1) 1st year PD = hazard rate = conditional p of default if there was no default before
2) t year PD = PS(t-1) * hazard rate
3) t year LGD = (1-recovery rate) * exposure(t) or loss severity * exposure(t)
4) t year PS = (1-hazard rate)^t
5) CVA = sum of PV of expected loss(t)
6) t year expected loss = LGD(t)*PD(t)

64
Q

Module 31.1, LOS 31.a

How recovery rate and implied probability of default are related?

A

Positively - the higher the recovery rate -> the higher the PD implied

65
Q

Module 31.1, LOS 31.a

Which difference in price does CVA represent?

A

CVA = risk-free bond P - risky bond P

66
Q

Module 31.3, LOS 31.b

What is the most popular scoring system in USA? What are it’s components?

A

FICO gives higher rating to:

1) longer credit histories (age of oldest account)
2) absence of delinquencies
3) lower utilization (outstanding balance divided by available credit line)
4) fewer credit inquires
5) a wider variety of types of credit used

67
Q

Module 31.3, LOS 31.c

How to calculate the expected return on a bond given transition in its credit rating?

A

Δ%P = – (modified duration of the bond) × (Δ spread)

68
Q

Module 31.3, LOS 31.b

Differences in which metric reflects notching procedure?

A

In LGD

69
Q

Module 31.3, LOS 31.b

Which parameters does credit rating incorporate?

A

PD and LGD. LGD due to notching for subordination

70
Q

Module 31.4, LOS 31.d

What are the main assumptions of structural models?

A

1) Simple balance sheet structure, no off-balance
2) PD is endogenous
2) utilizes option pricing model to value risky debt:
- value of equity(T) = max (0, A(T) − K)
value of debt = A(T) − value of equity = A(T) − max (0, A(T) − K)=min (A(T), K); or
- value of the put option = max (0, K − AT) = CVA
3) company assets traded on the market

71
Q

Module 31.4, LOS 31.d

What are the main advantages and disadvantages of structural models?

A

Advantages:

1) provide an economic rationale for default (i.e., AT < K) and explain why default occurs
2) utilize option pricing models to value risky debt

Disadvantages:

1) assume a simple balance sheet structure, complex balance sheets cannot be modeled.
2) when companies have off-balance sheet debt, the default barrier (K) would be inaccurate
3) assumes that assets of the company are traded in the market -> impractical model

72
Q

Module 31.4, LOS 31.d

What are the main assumptions of reduced form models?

A

1) do not rely on BS structure
2) do not assume that assets of the company are traded on the market
3) does not explain why default happens
4) statistically models when default occures - default is a randomly occurring exogenous variable
5) key input - default intensity (PD over the next (small) time period) - can be estimated with regression with predictors of company-specific and macro variables

73
Q

Module 31.4, LOS 31.d

What are the main advantages and disadvantages of reduced form models?

A

Advantages:

1) do not assume that the assets of a company trade
2) default intensity is allowed to vary as company fundamentals change, as well as when the state of the economy changes

Disadvantages:

1) do not explain why default occurs
2) default is treated as a random event (i.e., a surprise), but in reality, default is rarely a surprise

74
Q

Module 31.6, LOS 31.f

What are the components of credit spread?

A

Credit spreads include compensation for default, liquidity, and taxation risks relative to the benchmark.

Adjustment to the price for all these risk factors together is known as the XVA
Adjustment for default only is CVA

75
Q

Module 31.6, LOS 31.g

What are the key determinants of credit spread term structure?

A

1) Credit quality
2) Financial conditions (boom or downturn)
3) Market demand and supply (liquidity issues)
4) Equity market volatility (company-value models (structural models) employ a company’s stock price volatility and balance sheet structure in determining the probability of default)

76
Q

Module 31.7, LOS 31.h

What are the main components of credit analysis of secured debt?

A

1) Collateral pool (granular and homogenous?)
2) Servicer quality (good history?)
3) Structure of the pool + credit enhancements

77
Q

Module 31.7, LOS 31.h

What is covered bondt?

A

Covered bonds are senior, secured bonds backed by a collateral pool as well as by the issuer (i.e., covered bond investors have recourse rights)

common forms are commercial and residential mortgages and public sector loans

78
Q

Module 31.7, LOS 31.h
Which approach is best used when evaluating granular and homogenous structured finance vehicles in:
1) mid-term?
2) short-term?

A

1) portfolio-based approach (because the portfolio composition varies over time)
2) statistical-based approach

79
Q

Module 31.7, LOS 31.h

Can structural and reduced form models be used to evaluate ABS?

A

Yes, as long as they take into account the complex structure of the ABS

80
Q

Module 32.1, LOS 32.a

How face value of protection in CDS is called?

A

Notional principal

81
Q 
Module 32.1, LOS 32.a
Which coupons (standartization principle) CDS can have?
A

Fixed coupon on CDS products: 1% for investment-grade securities and 5% for high-yield securities

82
Q

Module 32.1, LOS 32.a

When Single name CDS pays off and what is the main principle and amount of payoff?

A

Pays off when:

1) the reference entity defaults on the reference obligation
2) the reference entity defaults on any other issue that is ranked pari passu (i.e., same rank) or higher

Payoff principle - cheapest-to-deliver (CTD) of the bond with same seniority:

payoff = notional principle − (% of par traded CTD)(notional principle)

83
Q

Module 32.1, LOS 32.a

For an index CDS, what is the protaction notional and what is the protection notional for each individual issuer?

A

protaction notional = sum of the protection on all the issuers
all issuer protections are equal (inex is equally weighted)

84
Q

Module 32.1, LOS 32.a

How CDS spread in index CDS depend on correlation of constituents?

A

The higher the correlation of default among index constituents, the higher the spread on the index CDS

85
Q

Module 32.1, LOS 32.b

Which credit events exist on CDS?

A

1) Bankruptcy
2) Failure to pay
3) Restructuring

86
Q

Module 32.1, LOS 32.b

Who and when declares credit event on CDS?

A

Determinations Committee (DC) with supermajority of votes (12/15)

87
Q

Module 32.1, LOS 32.b

Which settlements schemes in case of credit event on CDS exist?

A

1) Physical Settlement - protection seller receives the reference obligation (i.e., the bond or loan) and pays the protection buyer the notional amount
2) Cash Settlemet - the payout amount is the payout ratio times the notional principal, payout ratio = 1 − recovery rate (%), or is difference between notional and market value

88
Q

Module 32.2, LOS 32.с

What are the factors that influence the pricing of CDS?

A

1) probability of default
2) loss given default
3) coupon rate on the swap

89
Q

Module 32.2, LOS 32.с
How can CDS spread be estimated for:
1) single period?
2) multiple periods?

A

1) single period - CDS spread ≈ (1 – recovery rate) × PD
2) multiple periods -
CDS spread = upfront premium%/duration + CDS coupon
where upfront payment (by protection buyer) = PV(protection leg) − PV(premium leg)

90
Q

Module 32.2, LOS 32.с

How can CDS price be approximated?

A

price of CDS (per $100 notional) ≈ $100 − upfront premium (%)

91
Q

Module 32.2, LOS 32.с

How can profit for protection buyer be approximated?

A

profit for protection buyer (%) ≈ change in spread (%) × duration

92
Q

Module 32.2, LOS 32.с

What monetizing the gain is for CDS buyer?

A

A protection buyer can remove his exposure to the CDS by selling protection with the same terms as the original CDS and maturity equal to the remaining maturity on the existing CDS

93
Q

Module 32.3, LOS 32.d

What is a curve trade?

A

Curve trade is a type of long/short trade where the investor is buying and selling protection on the same reference entity but with a different maturity.

If seller beleives in curve flattaning, he will buy shorter maturity and sell protection for longer maturity

94
Q

Module 32.3, LOS 32.d

What is a long/short trade?

A

An investor purchases protection on one reference entity while simultaneously selling protection on another (often related) reference entity to eran on difference in their credit spreads

95
Q

Module 32.3, LOS 32.e

How to exploit profit from basis trade on CDS?

A

For example, bond is trading at a credit spread of 4% over LIBOR in the bond market but the CDS spread on the same bond is 3%, a trader can profit by buying the bond and taking the protection buyer position in the CDS market. If the expected convergence occurs, the trader will make a profit.

96
Q

Module 32.3, LOS 32.e

How to exploit profit from CDS when LBO is expected?

A

The firm will issue a great amount of debt in order to repurchase all of the company’s publicly traded equity. This additional debt will increase the CDS spread. An investor who anticipates an LBO might purchase both the stock and CDS protection, both of which will increase in value when the LBO eventually occurs

CFA level 2 Feb2022 (5 decks)

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