HOFIS 2

Question 1

What is interest rate level risk? and what is its most commonly used risk measure?

Answer 1

Exposure to level interest rate changes.

Duration.

Question 2

What is yield curve risk? and what is its most commonly used risk measure?

Answer 2

Exposure to changes in the shape of the yield curve.

Key rate duration

Question 3

Cases when reinvestment risk is higher

Answer 3

Higher for longer holding periods and bonds with large coupons

Question 4

Disadvantages of Call provisions from investor’s perspective

Answer 4

1. cash flow is uncertain
2. introduces reinvestment risk
3. reduces capital appreciation (call price is a ceiling on value)

Question 5

Two types of reinvestment or prepayment risk for MBS

Answer 5

1. contraction risk: risk that homeowners prepay when rates fall
2. extension risk: risk that mortgage pool will pay down more slowly than expected

Question 6

Three types of credit risk

Answer 6

1. default risk: risk that the issuer will default on its obligation
2. credit spread risk: the market may require higher spreads due to a perceived increase in default risk
3. downgrade risk: ratings companies may assign a lower rating, which would lead to a decline in bond value.

Question 7

Market bid/ask spread as liquidity risk measure

Answer 7

Difference b/w the best (highest) bid price and the lowest ask price

Question 8

Which type of bonds are exposed to volatility risk?

Answer 8

Bonds with embedded options