Fixed Income Flashcards
Shortcomings of the pure expectations theory
Ignores price risk and reinvestment risk
Explain pure expectations theory
Forward rates are solely a function of expected future spot rates
- upward sloping yield curve indicates rising ST rates
- downward sloping yield curve indicates falling ST rates
Explain liquidity preference theory
Forward rates reflect expectations of future spot rates plus a liquidity premium
- positively sloped yield curve»_space; rates expected to be flat (or slightly down) but liquidity premium added or rates expected to rise
Explain preferred habitats theory
Forward rates represent expected rates plus a premium based on supply and demand for funds at different maturities
How to calculate annualized volatility
(daily standard dev)*SQRT(# of trading days)
Calculate confidence interval for yield
Yield +/- standard deviation
Where standard deviation = (ann std dev) x (yield) x (# of std devs)
What is Z spread?
Spread added to each spot rate to make the PV of the cash flows equal to the bond’s price
= OAS + option cost
Value of a call option on a bond
Value of noncallable - value of callable
Value of an embedded put option for a bond
Value of putable bond - value of nonputable bond
Bonds with spreads larger than the required spread are considered ________
Undervalued/cheap
Credit spreads include compensation for ___, ___, and ___
- credit risk, liquidity risk and option risk
- probability of default, LGD, time value of money and risk premium
Increased stock volatility will ____ the value of a callable convertible bond
Increase because value of the call option on the stock increases
Increase in interest rate volatility will ____ the value of the callable convertible bond
Reduce because the value of the call option on the bond increases
Conditional prepayment rate (CPR)
Annual rate at which a mortgage pool balance is assumed to be prepaid during the life of the pool
Single monthly mortality rate
1 - (1-CPR)^(1/12)
PSA prepayment benchmarks for 100 PSA
First 30 months: (month*0.2%) per month
Months 30-360: 6% per month
Estimated prepayment amount for any given month
SMM*(beg monthly mortgage balance - scheduled principal payment for the month)
Z tranche or accrual tranche
Last tranche that does not receive current interest until the outstanding principal of the other tranches have been repaid
Planned amortization class (PAC) CMO
Pays the lesser amount of the repayment schedule which is based on a lower prepayment rate and an upper rate of the initial PAC collar
Support tranche
- Part of a PAC CMO to collect the excess principal payments or provide principal
- Higher average life variability
Return impact of spread changes
(-duration x Δspread) + (0.5 x convexity x (Δspread)^2)
Effective duration
(Pd - Pu)/(2 x P x Δyield)
Pd = price if rates went down Pu = price if rates went up P = current price
Effective convexity
(Pd + Pu - 2 x P)/(2 x P x Δyield^2)
Pd = price if rates went down Pu = price if rates went up P = current price
Expected loss
=PD*LGD
Weakness of structural model
- assumes a firm’s assets can be traded in a frictionless market
- requires firm’s equity to be publicly traded and model to match market’s actual structure
Reduced form models
Applies a constant PD for all of a firm’s liabilities but different loss rates
PV of expected loss on a bond
Sum of PV of cash flows based on credit spread (spot rate of risky bond - spot rate of risk-free bond)
Change in bond price
(-ED x Δyield x 100) + (EC x (Δyield)^2 x 100)
