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CFA > Fixed income > Flashcards

Fixed income Flashcards

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1
Q

What does f(2,1) mean?

A

Forward rate, 2 years from today, 1 year until maturity

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2
Q

What is “riding the yield curve”?

A

Process of buying bonds whose maturities are longer than investment horizon

Works when yield curve is upward sloping

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3
Q

What is the swap rate?

A

Interest rate for fixed-rate leg of swap

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4
Q

What is the swap spread?

A

Spread between fixed-rate of an interest rate swap & most recently issued government security with same maturity

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5
Q

What is the Z-spread?

A

Constant basic point spread to add to the implied spot yield curve such that the discounted cash flows of a bond are equal to its current market price

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6
Q

What is the TED spread?

A

Spread between US T-bill and LIBOR: measure of counterparty risk

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7
Q

What is the LIBOR-OIS spread?

A

Indicator of risk and liquidity of money market securities

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8
Q

What are the principal movements of the yield curve

A

1) Level
2) Steepness
3) Curvature

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9
Q

What is the Local Expectations Theory?

A

A term structure theory that contends the return for all bonds over short time periods is the risk-free rate.

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10
Q

What is the Pure Expectations Theory?

A

A term structure theory that contends the forward rate is an unbiased predictor of the future spot rate. Also called the unbiased expectations theory.

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11
Q

What is the Liquidity Preference Theory?

A

A term structure theory that asserts liquidity premiums exist to compensate investors for the added interest rate risk they face when lending long term.

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12
Q

What is the Segmented Markets Theory?

A

A term structure theory that contends yields are solely a function of the supply and demand for funds of a particular maturity.

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13
Q

What is the Preferred Habitat Theory?

A

A term structure theory that contends that investors have maturity preferences and require yield incentives before they will buy bonds outside of their preferred maturities.

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14
Q

What are the characteristics of the CIR (Cox) model?

A

Mean-reversing

Interest rate volatility increases with the level of short-term interest rate

Economy has constant long-run interest rates that ST interest rates converge to

Does NOT generate negative interest rates

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15
Q

What are the characteristics of the Vasicek model?

A

Tends to mean reversion
Assumes volatility remains constant over period
Possible for interest rate to become negative

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16
Q

What are the characteristics of the Ho-Lee model?

A

Most accurate modeling

Takes the current yield curve as given and produces a symmetrical distribution of future rates

Can generate negative interest rates

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17
Q

Using binomial interest rate tree, what is the bond value at each nod?

A

0.50*( (VH+C)/(1+i) + (VL+C)/(1+i) )

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18
Q

Does valuation using zero-coupon yield curve and binomial interest rate tree generate the same result?

A

Yes

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19
Q

What are the effects of volatility on option-embedded bonds?

A

Value of putable bond increase when volatility increase

Value of callable bond decrease when volatiity increase

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20
Q

Which option-embedded bonds have more upside when interest rates fall?

A

Putable bonds; more sensitive to interest rate decreases

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21
Q

Which option-embedded bonds have more upside when interest rates increase?

A

Callable bonds; more sensitive to interest rate increases

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22
Q

What is the formula for effective duration?

A

( (PV-) - (PV+) ) / (2 * Change * PV0)

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23
Q

Which option-embedded bond can have negative convexity?

A

Callable bonds when option is near the money

24
Q

What is the formula for effective convexity?

A

( (PV-) + (PV+) - (2 * PV0) ) / ( (Change)^2 * PV0 )

25
Q

What is the effective duration of floater?

A

Close to time to next reset

26
Q

What is the conversion value?

A

Underlying share price x Conversion ratio

27
Q

What is the market conversion price?

A

Convertible bond price / Conversion ratio

28
Q

What is the market conversion premium ratio?

A

Market conversion premium per share / Underlying share price

29
Q

What is the premium over straight value

A

(Convertible bond price / Straight value) - 1

30
Q

What are the 2 modifications to the PV of expected loss?

A

1) Adjust probabilities to account for risk of cash flows (risk premium)
2) Discounting future cash flows (time value)

31
Q

What is the expected loss formula?

A

Probability * Loss given default

32
Q

What are the assumptions of the structural model?

A

Simple balance sheet consisting of a single liability (zero-coupon bond)
Assets trade and are observable
Interest rates constant over time (not true in practice)
Volatility is constant over time, independent of changing economic conditions and business cycles
Inputs can be estimated only using calibration

33
Q

What is the option analogy of the structural model?

A

Company’s equity: European call option

Owning riskless debt & selling European put option

34
Q

What are the assumptions of reduced form models?

A

1) Consider also company’s traded liabilities
2) Require borrower has a zero-coupon bond that trades in arbitrage-free and frictionless markets
3) Can be estimated using calibration or historical estimation

35
Q

What is the main characteristic of ABS?

A

They do NOT default; probability of default does NOT apply

36
Q

What is the formula for probability of debt defaulting using reduced form?

A

1 - e^(Default intensity * (T - t))

37
Q

What is the expected loss using reduced form?

A

Face value * (1 - e^(Default intensity * (T - t)))

38
Q

What is the PV of credit spread?

A

Upfront premium + PV of fixed coupon

39
Q

What is the upfront premium formula?

A

(Credit spread - Fixed coupon) x Duration

40
Q

What is the price of CDS per 100?

A

100 - Upfront premium%

41
Q

How can OAS can be used to identify underpriced/overpriced bonds?

A

If OAS of the bond being analyzed is > OAS of benchmark bonds (similar characteristics and credit quality): bond is underpriced.

42
Q

What is the impact of interest rate volatility on OAS?

A

Decrease in volatility: increase OAS for callable bonds
Increase in volatility: increase OAS for putable bonds

If OAS increases, the relative cheapness increases.

43
Q

What happens when interest rate volatility stays the same, but yield curve flattens?

A

Value of callable bonds and putable bonds will increase, but not less rapidly than a straight-bond.

44
Q

When the yield curve moves from flat to upward sloping, what happens to option-embedded bonds?

A

Putable bonds: Value increases

Callable bonds: Value decreases

45
Q

What are some strengths of structural model?

A

It provides an option analogy for understanding a company’s default probability and recovery rate.

It can be estimated using only current market prices.

46
Q

What are some weaknesses of structural model?

A

The default probability and recovery rate depend crucially on the assumed balance sheet of the company, and realistic balance sheets cannot be modeled.

Its credit risk measures can be estimated only by using implicit estimation procedures because the company’s asset value is unobservable.

Its credit risk measures are biased because implicit estimation procedures inherit errors in the model’s formulation.

The credit risk measures do not explicitly consider the business cycle.

47
Q

What are some strengths of reduced form model?

A

The model’s inputs are observable, so historical estimation procedures can be used for the credit risk measures.

The model’s credit risk measures reflect the changing business cycle.

The model does not require a specification of the company’s balance sheet structure.

48
Q

What are some weaknesses of reduced form model?

A

Hazard rate estimation procedures use past observations to predict the future. For this to be valid, the model must be properly formulated and back tested.

49
Q

What is the formula for conversion ratio?

A

Bond face value / Initial conversion price

50
Q

What is the effect of a cash dividend higher than threshold dividend?

A

Reduction in the conversion price; increase the conversion ratio

51
Q

Compare to option-free bonds, what is the level of the coupon rate for a convertible bond?

A

Typically lower

52
Q

What are the inputs necessary to a reduced form model?

A

1) One of the liabilities must trade
2) Macroeconomic variable (GDP, inflation)
3) Risk-free rate

53
Q

If expected future spot rates are higher than current forward rates, is the bond overvalued or undervalued?

A

Overvalued

This is so because the market is discounting the future cash flows at too low a discount rate compared to investor expectations, leading to too high a valuation for the bond.

54
Q

An increase in volatility will cause forward rates to…

A

Spread out

55
Q

Mean reversion has the impact of moving interest rates towards…

A

Forward rates implied from the yield curve

CFA (10 decks)

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