Fixed Income

Question 1

Z-Spread

Answer 1

Z-Spread – the constant basis point spread that needs to be added to the implied spot yield curve such that the discounted cash flows of a bond are equal to its current market price (↑ Z-spread  ↑risky bond)

Question 2

TED Spread

Answer 2

TED Spread – a measure of perceived credit risk determined as the difference between Libor and the T-bill yield of matching maturity

Question 3

Pure Expectations Theory

Answer 3

Pure Expectations Theory – contends the forward rate is an unbiased predictor of the future spot rate

Question 4

Local Expectations Theory

Answer 4

Local Expectations Theory – contends the return for all bonds over short time periods is the risk-free rate

Question 5

Liquidity Preference Theory

Answer 5

Liquidity Preference Theory – contends the liquidity premiums exist to compensate investors for the added interest rate risk they face when lending long term

Question 6

Segmented Market Theory

Answer 6

Segmented Market Theory – contends yields are solely a function of the supply and demand for a particular maturity

Question 7

Preferred Habitat Theory

Answer 7

Preferred Habitat Theory – contends that investors have maturity preferences and require yield incentives before they will buy bonds outside of their preferred maturities

Question 8

Forward Rate Model (breakeven rate, to be indifferent)

Answer 8

Forward Rate Model (breakeven rate, to be indifferent): [1+r(T+T)](T+T) = [1+r(T)]T[1+f(T,T)]T solve for f(T,T) which is the T-year rate, T* years forward

Question 9

Libor-OIS Spread

Answer 9

Libor-OIS Spread – the difference between Libor and the overnight indexed swap (OIS) rate

Question 10

Bond value at a node

Answer 10

Bond value at a node = 0.5* [(VH+C)/((1+i))+ (VL+C)/((1+i))] , C-coupon, VH/L-bond value if high/low forward rate used

Question 11

Arbitrage Opportunity (Bonds)

Answer 11

Arbitrage Opportunity (Bonds): compare value of bond’s cash flows using spot rates (=∑_(t=1)^n▒Coupon/〖(1+Year t Spot)〗^t +(Coupon+Par)/〖(1+Year n Spot)〗^n ) with market price

Question 12

Monte Carlo simulation

Answer 12

Monte Carlo simulation, a constant is added to all interest rates on all paths such that the values estimated for each benchmark bond equals its market price

Question 13

Value of a Callable Bond =

Answer 13

Value of a Callable Bond = Value of a Straight Bond – Value of Issuer Call Option

Question 14

Value of Putable Bond =

Answer 14

Value of Putable Bond = Value of a Straight Bond + Value of Investor Put Option

Question 15

↓ interest rate volatility [effect on call, put, option-free]

Answer 15

↓ interest rate volatility  ↓ value call & put option, no effect on option free

Question 16

Yield curve flattens (interest rates ↓) [call an put option]

Answer 16

Yield curve flattens (interest rates ↓)  ↑ value of call option, ↓ value of put option

Question 17

Effective Duration =

Answer 17

Effective Duration = (〖PV〗– 〖PV〗+)/(2(∆curve)〖PV〗_0 )

Question 18

Market Conversion Price =

Answer 18

Market Conversion Price = Convertible Bond Price / Conversion Ratio

Question 19

Bermuda

Answer 19

Bermuda – predetermined scheduled dates

Question 20

Credit Ratings

Answer 20

Credit Ratings – ordinal rankings

Question 21

In a structural model, the company’s …

Answer 21

In a structural model, the company’s equity can be viewed as a European call option on the assets of the company, with a strike price equal to the debt’s face value

Question 22

Reduced form models …

Answer 22

Reduced form models of credit risk consider a company’s traded liabilities (debt)

Question 23

Credit Ratings, weaknesses (3)

Answer 23

Credit Ratings, weaknesses: tend to be stable over time, don’t explicitly depend on the business cycle even though default probability does, issuer-pays model for compensating credit-rating agencies has a potential conflict of interest that may distort the accuracy of credit ratings