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CFA Level 2 > Fixed Income > Flashcards

Fixed Income Flashcards

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1
Q

Calculate exposure for each year of a bond

A

Take the final payout date and discount by the yield and add in the coupons along the way (1 year at a time)

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2
Q

Given exposure, default probability, and recovery amounts, calculate riskiest bonds

A
  • find expected loss by taking (exposure - recovery) * default probability and the high expected loss is the riskiest bond
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3
Q

Two broad categories that cover credit risk models

A

1) Reduced Form
2) Structural

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4
Q

Reduced form credit model

A
  • seek to predict when a default may occur, but not why
  • based only on observable variables
  • says credit evens are exogenous and random
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5
Q

Structural Model

A
  • Based on an option perspective of the stakeholders of the company
  • Bondholders are viewed as owners of the assets of the company, while shareholders have the call options on those assets
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6
Q

Hazard Rate

A

The probability that an event will occur, given that it has not already occurred

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7
Q

Upfront payment on a CDS

A

PV(protection leg) - PV(premium leg), basically whoever’s value is more has to pay the difference

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8
Q

Upfront premium

A

(credit spread - fixed coupon) *duration

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9
Q

Naked CDS

A

A position in which the holder does not have a position in the underlying

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10
Q

Curve Trade

A

buying a CDS of one maturity and selling a CDS on the same reference of a different maturity

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11
Q

Basis trade

A

A trade based on the pricing of credit in the bond market vs the price of the credit in the CDS market. To executive, go long the underpriced credit and short the overpriced credit until the two converge

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12
Q

Spot rate

A

The interest rate that is determined today for a risk-free, single unit payment at a specified future date

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13
Q

Spot curve

A

YTM’s on a series of default-risk-free zero coupon bonds

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14
Q

Forward Rate

A

An interest rate determined today for a loan that will be initiated in a future period

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15
Q

Forward Curve

A

A series of forward rates, each having the same time frame

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16
Q

Par Curve

A

A sequence of YTM’s such that each bond is priced at par value, where each bond are assumed to have the same currency, credit risk, liquidity, tax status, and annual yields stated for the same periodicity

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17
Q

Bootstrapping

A

The use of a forward substitution process to determine zero coupon rates by using the par yields and solving for the zero-coupon rates one by one

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18
Q

Rolling down the yield (riding the yield curve)

A

A maturity trading strategy that involves buying bonds with a maturity longer than the intended investment horizon

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19
Q

Swap rate

A

Fixed rate to be paid by the fixed-rate payer

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20
Q

Par Swap

A

A swap in which the fixed rate is set so that no money is exchanged at contract initiation

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21
Q

Swap spread

A

Difference between fixed rate on interest rate swap and the rate on a treasury

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22
Q

I Spread

A

Reference to linearly interpolated yield

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23
Q

TED spread

A

a measure of perceived credit risk, difference between Libor and t bill

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24
Q

OIS Spread

A

difference between LIBOR and overnight indexed swap rate

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25
Q

Local expectations theory

A

Return for all bonds over short periods is the risk free rate

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26
Q

3 Factors that explain yield curve shape changes

A

1) Level - explains the most
2) Steepness
3) Curvature

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27
Q

Bearish flattening

A

Short-term bond yields rise, curve goes flat

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28
Q

Bullish steepening

A

Short-term rates fall, curve goes steep

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29
Q

Bullish flattening

A

Long-term rates fall, curve goes flat

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30
Q

Bullet portfolio

A

A fixed income portfolio concentrated in a single maturity

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31
Q

Dominance principle

A

arbitrage opportunity when a financial asset with a risk-free payout in the future must have a positive price today

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32
Q

Cox-Ingersoll-Ross Model (CIR)

A

Model that assumes interest rates are mean reverting and interest rate volatility is directly related to the level of interest rates

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33
Q

Vasicek Model

A

Interest rates are mean reverting and interest rate volatility is constant

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34
Q

Ho-Lee Model

A
  • The first arb model, calibrated to market data and uses a binomial lattice approach to generate a distribution of possible future interest rates
  • Can be calibrated to closely fit an observed yield curve
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35
Q

Kalotay-Williams-Fabozzi Model (KWF)

A

Describes the dynamics of the log of the short-rate and assumes constant drift, no mean reversion, and constant volatility

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36
Q

Effective duration definition and formula

A

sensitivity of the bond’s price to an instant parallel shift in a benchmark yield curve, for example, the government par curve

(v minus - v plus) / (2v0change in yield)

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37
Q

Conversion Price

A

For a convertible bond, the price per share at which the bond can be converted into shares

Market price of convertible bond / conversion ratio

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38
Q

Conversion Rate (ratio)

A

The number of stock that bondholder receives from converting the bond into shares

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39
Q

When would a forced conversion happen

A

when underlying share prices increases above the conversion price

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40
Q

Conversion Value

A
  • Parity Value
  • market price of stock * conversion ratio
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41
Q

Expected Exposure

A

Projected amount of money an investor could lose if an event of default occurs, before factoring in possible recovery

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42
Q

Credit Valuation Adjustment

A

The value of the credit risk of a bond in present value terms

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43
Q

Index CDS

A

A type of CDS that involves a combination of borrowers

44
Q

Credit correlation

A

the correlation of credit risks of the underlying single name CDS contained in an index CDS

45
Q

Roll

A

When an investor moves its investment position from an older series to the most current series

46
Q

Protection Leg

A

The contingent payment that the credit protection seller may have to make to the credit protection buyer

47
Q

Calculate the spread the market expects for credit and liquidity component of the YTM

A

The swap spread is measured over the “on-the-run” swaps, so calculate the on the run ytm and then the sap rate and subtract the two

48
Q

CDS Trade - Flattening of Curve

A
  • sell long-term CDS
  • buy short term CDS
49
Q

CDS trade - steepening of curve

A
  • buy long-term CDS
  • sell short-term CDS
50
Q

Advantages of using Monte Carlo to simulate interest rate paths

A

1) increases the number of paths increases the estimate’s statistical accuracy

51
Q

Does monte carlo provide a closer value to bond’s true fundamental value

A

No

52
Q

Credit Score

A
  • Used primarily in retail lending market and for small businesses
  • sometimes only negative information, like delinquent or default is included
53
Q

Advantages of using swap curve as a benchmark of interest rates relative to government bond yield curve

A

Some countries do not have active government bond markets with trading at all maturities, so with an active swap market, there are typically more points available to construct

54
Q

Segmented Market vs. Preferred Habitat Theories

A
  • Both try to explain the shape of any yield curve in terms of supply and demand
  • Segmented market theory says investors are limited to purchase maturities that match the timing of their liabilities
  • Preferred habitat says investors have a preferred maturity for asset purchases, but may deviate if they feel returns in other maturities offer sufficient compensation
55
Q

OAS on callable bond when volatility drops

A

increases

Callable bond = value of straight bond - value of call option

56
Q

OAS on puttable bond when volatility drops

A

decrease

Puttable bond = value of straight bond + value of put option

57
Q

Typical impact of credit rating migration on the expected return on a bond

A

Typically reduces the expected return for two reasons:
1) Probabilities for rating changes are not symmetrically distributed, they are skewed towards a down rating
2) Increase in the credit spread is much larger for downgrades than is the decrease in the spread for upgrades

58
Q

Long-Short Trade when economy strengthens using HY and IG

A

selling CDS on HY and buying CDS on IG because credit spreads narrow

59
Q

One benefit of testing that the binomial interest rate tree has been properly calibrated to be arbitrage-free

A

Enabling the model to price bonds with embedded options

60
Q

Conversion premium ratio

A

1) Par Value (1,000) / current conversion price = current conversion ratio
2) Current trading price / current conversion ratio = market conversion price
3) Market conversion premium = market conversion price / current share price

61
Q

Value of embedded put option when interest rates increase

A

Put option increases

62
Q

Value of embedded call option when yield curve flattens

A

Call options increases

63
Q

Value of a convertible bond with an embedded call option and put option

A

Value of straight bond + value of call option on stock - value of issuer call option + value of put option

64
Q

Market conversion premium per share

A

1) Market conversion price = convertible bond price / conversion price
2 Market conversion premium per share = market conversion price - underlying share price

65
Q

Value of put option when yield curve moves from being upward sloping to flat to downward sloping

A

Value of put option decreases

66
Q

Z spread

A

single rate that when added to the rates of the spot yield curve, provide the correct discount rate to price a corporate bond

67
Q

Spot rate determined by using forward substitution

A

1 = (par rate in year you want / 1+spot rate in year 1) + (par rate in year you want / 1 + spot rate in year 2) … + (1 + par rate in year you want / 1 + spot rate in final year (which you are solving for))

68
Q

What is the typical term structure of interest rate volatility

A

downward sloping

69
Q

Spread that reflects risks and liquidity in money market securities

A

MRR-OIS Spread

70
Q

spread that reflects risk in the banking sector

A

TED spread

71
Q

A swap curve is a type of what curve

A

par curve

72
Q

which theory of term structure interest rates does not have a supply and demand argument

A

liquidity preference

73
Q

where does short-term interest rate volatility come from and where does long-term interest rate volatility come from

A

short-term = monetary policy uncertainty
long-term = real economy and inflation

74
Q

effective duration of floating rate bond

A

close to the time to next market reset

75
Q

Effective duration formula

A

[(PV-) - (PV+)]/ [2* delta I-rate*(PV0)]

76
Q

Loss Severity

A

1 - Recovery Rate

77
Q

Expected price change as a result of credit rating change

A
  • Duration * (New credit rating credit spread - old credit rating credit spread)
78
Q

Risk neutral probability of default

A

100 = (exposure * (1-p) + cash flow in default * p) / (1 + r )

cash flow in default = default probability * exposure

79
Q

Gain/Loss in CDS trade

A

change in credit spread * duration * notional amount

80
Q

CDS up front premium

A

(credit spread - CDS fixed coupon) * duration

81
Q

On what level of debt is single name CDS typically issued

A

senior unsecured debt

82
Q

Price of CDS

A

1 - CDS up front premium

83
Q

Which approach for evaluating credit risk is most predictive

A

reduced form model

84
Q

Which approach for evaluating credit risk is least predictive

A

credit rating

85
Q

do credit spreads predict probability of default

A

no

86
Q

Impact of volatility on CVA

A

almost no impact

87
Q

why is a risk-neutral probability of default much higher than historically observed rates of default

A

the resulting credit spread should reflect uncertainty of payments

88
Q

term structure of credit spread of HG vs. IG vs. Distressed

A

HG = upward sloping
IG = flat to upward sloping
Distressed = downward sloping

89
Q

which credit model predicts probability of default

A

none of them

90
Q
A
91
Q

How should MBS be valued

A

Using Monte Carlo

92
Q

When underlying options are at or near the money, one sided down duration vs one sided up duration callable bonds

A

Lower

93
Q

When underlying options are at or near the money, one sided down duration vs one sided up duration on putable bonds

A

Higher

94
Q

When underlying options are at or near the money, one sided down duration vs one sided up duration on putable bonds

A

Higher

95
Q

Expected loss on CDS

A

Hazard rate * LGD

96
Q

Options analogies in structural model

A
  1. Equity investors have call option on assets
  2. Debt investors short a put option on assets
  3. Value of put option = CVA
97
Q

Value of call and put options when volatility increases

A

Both increase

98
Q

Value of callable bond when volatility increases

A

Decreases

99
Q

Value of putable bond when volatility increases

A

Increases

100
Q

OAS and value of callable bond when lower than actual volatility is used

A

OAS is too high so bond is underpriced

101
Q

OAS and value of putable bond when lower than actual volatility is used

A

OAS too low and putable bond is overpriced

102
Q

Standardized rate on CDS contract for HY

A

5%

103
Q

Standardized rate on CDS contract for IG

A

1%

104
Q

CDS trade for when credit curve shifts up at all points

A

sell short buy long

105
Q

the underlying of a CDS

A

the credit quality of the borrower

106
Q

CVA Formula

A

LGD * POD * discount factor

LGD = 1-recovery rate

107
Q

CVA Formula

A

LGD * POD * discount factor

LGD = 1-recovery rate * expected exposure

CFA Level 2 (11 decks)

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