Fixed Income

Question 1

The strategy of riding the yield curve is most likely to produce superior returns when the spot rate curve:

Answer 1

Is upward sloping and remains unchanged over time.

Question 2

What is the difference between Local expectations theory and unbiased expectations theory?

Answer 2

Risk neutrality only holds for short holding periods and over longer periods risk premiums should exist.

Question 3

When the yield curve is downward sloping, the forward curves are most likely to lie:

Answer 3

Below the spot curve

Question 4

What is the LIBOR-OIS spread?

Answer 4

Amount that LIBOR exceeds the overnight indexed swap.

Question 5

Liquidity preference theory reflects investors expectations of future price plus a liquidity premium. How is this related to maturity?

Answer 5

Positively. Bonds with longer maturity demand a larger liquidity premium.

Question 6

How is the premium to expected future rates related to maturity under the preferred habitat theory?

Answer 6

It does not directly relate to maturity but is derived by the imbalance between supply and demand for a given maturity. Enticing investors to change from their preferred maturity.

Question 7

Under which of the these two models does volatility increase with interest rate?

The Vasicek Model or The Cox-Ingersoll-Ross-Model

Answer 7

The Cox-Ingersoll-Ross model as the volatility term is dependent on the sqrt of short term interest rate.

Question 8

The measures that are used to identify and manage “shaping risk” are:

Answer 8

Sensitives to level, steepness, and curvature factors.

Question 9

What model do you use to value path dependent bonds?

Answer 9

Monte Carlo forward-rate simulation

Question 10

How are the forward rates on the 1st nodal period related between two nodes?

Answer 10

e^(2sigma)

Question 11

Which theory states that Investors expectation is what determines the shape of the interest rate term structure?

Answer 11

Unbiased expectation theory

Question 12

What are Ratchet bonds?

Answer 12

Specialised floaters with both issuer and investor options. The issuer option allows the coupon on the bond to reset lower when rates decline.

Investor option allows investor to put bond at par however the option can only be exercised if the coupon is reset.

Question 13

With respect to the value of a callable convertible bond, what happens when there is a decrease in interest rate volatility? What happens when there is a decrease in the underlying stock price volatility?

Answer 13

Decrease in Vol will increase value of a callable convertible bond.

Decrease in stock price Vol will decrease value of the callable convertible.

Question 14

What is the minimum value of a convertible bond?

Answer 14

The greater of its conversion value or straight value.

Question 15

Low-coupon callable bonds have the highest key rate duration corresponding to their time-to-exercise or time-to-maturity?

Answer 15

Time-to-maturity

Question 16

Low coupon putable bonds should have the highest key rate duration, corresponding to their time-to-maturity of time-to-exercise?

Answer 16

Time-to-exercise

Question 17

What are the three models for evaluating credit risk?

Answer 17

Credit ratings
Structural models
Reduced form model

Question 18

What are the three weaknesses of the Structural model?

Answer 18

1) Balance sheet cannot be realistically modelled using a single zero-coupon bond.
2) Company assets are not traded.
3) Estimation procedures do not consider the business cycle.

Question 19

What is a weakness of the reduced form model?

Answer 19

The hazard rate estimation procedure, which uses past observations to predict the future, may not be valid.

Question 20

The assumption that the risk-free interest rate is constant over time as opposed to being stochastic (varying randomly) applies to the reduced form or structural model?

Answer 20

Structural model. This implies that there is no interest rate risk.

Question 21

What do analysts use instead of probability of default when analysing ABS?

Answer 21

Probability of loss.

This is because the whole ABS does not default when one of the constituents defaults.

Question 22

What does a PAC tranche stand for and what two things does it reduce?

Answer 22

Planned amortisation class.

Reduces contraction and extension risk.

Question 23

What does the support tranche do with respect to the PAC tranche?

Answer 23

The support tranche has increased extension and contraction risk. It absorbs any repayment speed changes so that the PAC can continue to make predictable payments.

Question 24

What is a Synthetic CDO?

Answer 24

Collateral is a portfolio of CDS.

Question 25

The issuer of ABS is best described as a:

Answer 25

SPV

Question 26

If the assumed volatility is too high. What effect with this have on the OAS for a callable bond and will bond have been over or under valued?

Answer 26

It will reduce the OAS and thus undervalue the bond.