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CFA II > Fixed Income > Flashcards

Fixed Income Flashcards

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1
Q

What is the underlying assumption of the forward pricing model?

A

That the price of a zero-coupon bond is the equivalent to the price of a forward contract to purchase a zero-coupon bond that matures at the same time.

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2
Q

What is riding the yield curve?

A

Where the investor earns excess returns as the bond price increases towards par.

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3
Q

What shape must the yield curve be in order to ride it?

A

Upward sloping.

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4
Q

What is the swap spread and what risk does it represent?

A

It is the difference between the fixed rate on a swap and the yield on a treasury.

It represents credit and liquidity risk.

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5
Q

What is the formula for TED spread?

A

TED = (3 Month LIBOR) - (3 Month T-Bill)

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6
Q

What risk does the TED spread indicate?

A

Overall risk in the economy.

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7
Q

What risk doe the LIBOR-OIS spread indicate?

A

Credit risk.

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8
Q

What is the segmented markets theory?

A

That the yield curve is determined by the fact that different groups on investors have preference for specific maturities.

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9
Q

Out of monetary policy uncertainty and inflation uncertainty, which represents long-term and short-term volatility?

A

Short-term volatility reflects uncertainty over monetary policy.

Long-term volatility reflects uncertainty over inflation.

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10
Q

What does the Ho-Lee model do?

A

It uses current market prices to find the time-dependent drift that generates the current term structure.

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11
Q

What is the advantage and disadvantage of using a lognormal walk to calibrate a binomial interest rate tree?

A

Advantage: It ensures non-negative interest rates.

Disadvantage: Volatility is higher at higher interest rates.

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12
Q

What is the term that relates adjacent forward rates in a binomial interest rate tree?

A

log squared * standard deviation

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13
Q

Will a binomial tree value a bond as the same a) Spot Curve and b) Par Curve used to derive it?

A

Yes to both.

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14
Q

What is term for buying a bond and selling off the constituent cash flows?

A

Stripping.

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15
Q

What risk does the OAS reflect?

A

OAS removes the option risk so the only remaining risks are credit risk and liquidity risk (i.e. The risk of a corporate bond over a treasury)

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16
Q

What is the formula for Market Conversion Premium?

A

Market Conversion Premium = Implied Conversion Price - Market Price

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17
Q

What is the upside and downside of a convertible bond?

A

Upside: The bond has a price floor of a straight bond.

Downside: When the stock price is increasing, the bond will underperform due to the conversion premium.

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18
Q

What is the conversion price of a convertible bond?

A

The trigger price at which it can be converted to an equity share.

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19
Q

What is the formula for effective duration?

A

Effective Duration = (BV-y) - (BV+y) / 2 * BV0 * y

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20
Q

What is the formula for effective convexity?

A

Effective Convexity = (BV-y) + (BV+y) - (2 x BV0) / BV0 x y2

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21
Q

If current price is greater than the callable price, will the bond be called?

A

Yes.

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22
Q

If current price is greater than putable price, will the bond be put?

A

No.

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23
Q

Which has a higher duration, straight bonds or bonds with options?

A

Straight bonds.

Callable and putable bonds have lower duration because the options will be exercised if the price moves too far.

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24
Q

Are low coupon bonds likely to be a) Called and b) Put?

A

They are unlikely to be called as interest rates would have already been low to start with.

They are likely to be put as there is scope for interest rates to increase significantly.

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25
Q

If an option is likely to be exercised, what will be the highest key rate duration - time to maturity or time to exercise.

A

The duration that corresponds to time-to-exercise.

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26
Q

What convexity do straight bonds, putable bonds and callable bonds have?

A

Straight Bonds - Positive
Putable Bonds - Positive
Callable Bonds - Negative

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27
Q

What is the relationship between likelihood of exercise and duration?

A

As likelihood of exercise increases, duration decreases as there is a limit on how far the price can go.

28
Q

What are the differences between expected loss and PV of expected loss?

A

Expected loss uses default probabilities.

PV of expected loss uses risk-neutral probabilities.

29
Q

Is a simple balance sheet structure an assumption of reduced form or structural models?

A

Structural models.

The structural model assumes one class of debt, and assets that can be traded in frictionless markets.

30
Q

What are credit spreads and what risks do they reflect?

A

They are the yield spread of a corporate bond above a treasury, and reflect credit and liquidity risk.

31
Q

What does the structural model say?

A

Holding risky corporate debt is equivalent to holding risk-free debt and selling a put option on the assets of the company.

32
Q

What is the formula for PV expected loss of a cash flow?

A

PV Expected Loss = PV Risk-Free Cash Flow - PV Risky Cash Flow

33
Q

What is the formula for upfront premium paid on a CDS?

A

Upfront Premium = (CDS Spread - Coupon) x Duration x Notional Principal

34
Q

What is the process for selecting a replacement bond to settle the default of a CDS?

A
  1. Select a bond with the same seniority.
  2. Of the bonds with the same seniority, select the cheapest to deliver (CTD).
  3. Calculate payoff = (Notional Principal - Market Value of CTD)
35
Q

Does the hazard rate affect the premium leg or the payment leg of a CDS?

A

Both.

36
Q

If asked to calculate the value of a callable/ putable bond with an OAS, what should you do?

A

Add the OAS to each of the forward rates in the tree.

37
Q

Which of these models include a drift term to ensure mean reversion?

  1. Cox-Ingersoll Ross.
  2. Ho-Lee
  3. Vasicek
A

Cox-Ingersoll Ross and Vasicek.

38
Q

Which of these models assumes constant volatility?

  1. Cox-Ingersoll Ross.
  2. Ho-Lee
  3. Vasicek
A

Vasicek.

39
Q

Which of these models assumes volatility increasing with rates?

  1. Cox-Ingersoll Ross.
  2. Ho-Lee
  3. Vasicek
A

Cox-Ingersoll.

40
Q

How do you calculate the price of a forward rate given a series of spot rates?

A

Forward Price = (1 + Spot^t+1) / (1 + Spot^t)

41
Q

Do retail banks use the swap spread or govt. bond spread to measure risk?

A

Govt. bond yield.

42
Q

Do wholesale banks use swap spread or govt. bond spread to measure risk?

A

Swap spread.

43
Q

What is swap spread?

A

The difference between the fixed swap rate and govt. bond.

44
Q

What risk does TED spread reflect?

A

Risk in the banking system.

45
Q

Which term of the cox-ingersoll equation represents the mean reverting level?

A

b.

46
Q

What positions are involved in a bull put spread?

A

Long low put - short high put

47
Q

How do you calculate the value of a bond with an option to extend the maturity?

A

In the same way as a putable bond, with the option at the extension point.

48
Q

If volatility estimate of a binomial option model is too low, what is the effect on the OAS and the bond value?

A

If volatility is too low then the option will be undervalued, therefore the OAS and the bond will also be undervalued.

49
Q

Is duration an absolute value, or a percentage?

A

A percentage.

50
Q

What is greater, expected loss or PV expected loss?

A

PV expected loss can be higher or lower, depending on whether the risk premium outweighs the time value discount.

51
Q

According to the structural method of credit risk, what is company risk debt and company equity equivalent to holding?

A

Equity = Call on Firm’s Assets

Risky Debt = Risk-Free Debt - Short Put on Firm’s Assets

Note: Other liabilities can be used in place of risk-free debt.

52
Q

What is expected loss percentage equal to?

A

Expected Loss % = Corporate Bond Yield - Risk Free Rate

53
Q

How can a payer swap be replicated with swaptions?

A

Payer Swap = Long Payer Swaption - Short Receiver Swaption

If the premiums are equal then the exercise rate is equal to the market SFR.

54
Q

How can a callable bond be replicated?

A

Long Callable Bond = Long Option-Free Bond - Short Receiver Swaption

55
Q

What is the formula for calculating management fee of a private equity fund?

A

Mgmt Fee = Called Down Capital x Fee %

56
Q

What is the formula for NAV before distributions?

A

NAV before distributions =

Previous Ending NAV
+ Called Down Capital
- Mgmt Fee
+ Operating Results

57
Q

What is the formula for carried interest?

A

Carried Interest = NAV before distributions * Carried Interest %

58
Q

What is the formula for NAV after distributions?

A

NAV after distributions =

NAV before distributions

  • Carried Interest
  • Distributions
59
Q

What is the formula for forward price of a bond?

A

Forward Price = (Current Price - PV Next Coupon) *1 + r^(t/365)

60
Q

Does the reduced form model attribute default risk to macro or micro factors?

A

The reduced form-model assumes company-specific risk is the only default risk.

61
Q

What is the maximum amount an investor would pay to take on a risky bond?

A

PV expected loss.

62
Q

If PV expected loss is greater than expected loss, what does this mean for the value of the premium?

A

The premium must be greater than the time value of money.

63
Q

If the spot curve is upward sloping, will the forward curve lie above or beneath it?

A

Above it.

64
Q

When riding the yield curve, will PMs choose bonds with long or short maturities?

A

Long.

65
Q

Will short-term interest rate changes affect long or short-term volatility more?

A

They will only affect short-term volatility.

Long-term volatility is affected by inflation.

CFA II (11 decks)

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