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ILA Track > ILA-LPM E > Flashcards

ILA-LPM E Flashcards

1
Q

Describe 2 situations where disintermediation can occur

A
  1. Surrenders increase when CSV crediting rate < market rates
  2. Policy loan utilization increases when loan rates < CSV crediting rate
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2
Q

Describe how disintermediation has impacted the life insurance industry

A
  1. Requires assumptions for surrender rates triggered by interest rates
  2. Shorter liability durations ⇒ requires shorter asset durations (less yield)
  3. UL and VUL were created
  4. Unbundled insurance and investment components (booming term sales)
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3
Q

List 4 risk-related considerations for managing a life insurer’s portfolio

A
  1. Valuation concerns from rising interest rates (risk of surplus loss)
  2. Reinvestment risk from falling interest rates
  3. Credit risk in the asset portfolio
  4. Cash flow volatility
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4
Q

Describe risk-related considerations for managing a life insurer’s portfolio:

  • Cash flow volatility
A
  • Risk of delays in reinvesting cash flows from investments
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5
Q

Describe risk-related considerations for managing a life insurer’s portfolio:

  • Credit risk in the asset portfolio
A
  • Solutions: AVR, portfolio diversification
  • Accounting challenges: FAS 115
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6
Q

Describe risk-related considerations for managing a life insurer’s portfolio:

  • Reinvestment risk from falling interest rates
A
  • Must fund minimum guaranteed crediting rates
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7
Q

Describe risk-related considerations for managing a life insurer’s portfolio:

  • Valuation concerns from rising interest rates (risk of surplus loss)
A
  • Disintermediation: when interest rates rise, liabilities increase and asset MVs decreases
  • Solutions: RBC, ALM
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8
Q

What is the key return objective for life insurers?

A

Key objective: earn a positive net interest spread over crediting rates

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9
Q

Describe the importance of liquidity for life insurers

A
  • Liquidity has become more important as annuity sales have increased
    • Disintermediation risk increases as interest rates and inflation increase
    • Asset marketability risk – less liquid assets are harder to sell at a fair price
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10
Q

Describe how the following affect life insurance asset portfolio management

  • Taxes
A
  • insurers pay taxes on investment income in excess of credited amounts
  • Policyholders generally don’t pay tax on investment income inside policies
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11
Q

Describe how the following affect life insurance asset portfolio management

  • Insurance is heavily regulated
A
  • (mostly at state level)
  • Restrictions on eligible investments
  • Prudent investor rule (instead of “laundry list”)
  • Valuation method (NAIC’s Security Valuation Book)
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12
Q

Describe how the following affect life insurance asset portfolio management

  • Time horizon
A
  • varies by LOB (longer for life products, shorter for annuities)
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13
Q

List some items in a company-specific investment policy statement.

A
  1. Introduction (company name/description, intro to risk objectives)
  2. Investment philosophy (why the company invests)
  3. Investment goals, objectives, and constraints
  4. Return objectives (e.g. fund policyholder liabilities, grow surplus)
  5. Risk tolerance (competitive requirements, ALM, RBC, ratings, etc.)
  6. List of specific investment constraints (liquidity, horizon, taxes, regulatory, etc.)
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14
Q

Describe tactical asset allocation (TAA)

A
  • involves short-term adjustments
  • Creates active risk from active management
  • Adjustments might be frequent (e.g. monthly) or ad hoc​
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15
Q

Describe strategic asset allocation (SAA)

A
  • based on long-term objectives/expectations
  • Results in a policy portfolio (target weights for each asset class)
  • Aligns portfolio’s risk profile with the investor’s objectives
  • Only change if investor’s long-term objectives change
  • Superior to a “horse race”
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16
Q

Describe the results of empirical studies on the effect of asset allocation:

  • Terminal wealth impact: asset allocation vs. security selection
A
  • Security selection results in greater dispersion of terminal wealth
  • Conclusion: security selection can add value but also risk
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17
Q

Describe the results of empirical studies on the effect of asset allocation:

  • regression analysis
A
  • Various regression analysis studies show importance of asset allocation
    • Over 90% (R2) of portfolio returns are explained by asset allocation
    • Active management explains very little
    • Cross-sectional variations (differences across investors)
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18
Q

Describe the results of empirical studies on the effect of asset allocation:

  • what is the key takeaway?
A
  • asset allocation explains nearly all of long-term portfolio returns
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19
Q

List the key conclusions on SAA based on empirical studies

A
  • Sidestepping SAA has no empirical support
  • Active management can add value but also cost and risk
  • On average, active returns < passive returns

Conclusion: You can beat the average active investor by simply being passive

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20
Q

Compare and contrast asset–only vs asset and liability management

A
  • AO approach
    • No explicit liability model
    • Set policy portfolio irrespective of liabilities (any liability impact is indirect)
  • ALM approach
    • Optimize asset allocation relative to an explicit liability model
    • Early approaches: cash flow matching and immunization (duration and convexity)
    • Results in higher allocations to fixed income than AO
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21
Q

List the key investor-related considerations for choosing ALM

A
  • Below-average risk tolerance
  • High penalties for not meeting the liabilities
  • Interest-sensitive liabilities
  • Higher portfolio risk limits ability to profitably take risk in other activities
  • Holding fixed income securities is favored by:
    • Legal/regulatory requirements
    • Tax law

Life insurers should choose ALM

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22
Q

Describe qualitative return objectives with respect to SAA, and give an example.

A
  • ​Describes the investor’s fundamental goals
  • Example: “earn a sufficient return to fund all policyholder liabilities”
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23
Q

Describe some quantitative return objectives with respective to SAA

A
  • AO focus: absolute asset returns
  • ALM focus: asset returns net of liability growth
  • Arithmetic (additive) vs. multiplicative (geometric)
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24
Q

Describe some quantitative return objectives with respective to SAA

  • Arithmetic (additive) vs. multiplicative (geometric)
A
  • Arithmetic (additive) vs. multiplicative (geometric)
    • Geometric is better when long-term compounding is significant
    • Geometric results in a higher annual return requirement
    • Arithmetic may be appropriate if inflation/expenses are negligible
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25
Q

List some quantitative methods for evaluating risk tolerance

A
  1. Mean-variance approach
  2. Discard portfolios if standard deviation is above a cutoff
  3. Minimize shortfall risk
  4. Minimize probability of not meeting threshold return
  5. Work with standard deviation multiples
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26
Q

Describe some quantitative methods for evaluating risk tolerance:

  • Minimize probability of not meeting threshold return
A
  • (same result as minimizing shortfall risk)
  • Minimize explicit probability: Pr[RP < RL] = Ø(-SFRatio)
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27
Q

Describe some quantitative methods for evaluating risk tolerance:

  • Minimize shortfall risk
A
  • risk of falling below a threshold return
  • Maximize Roy’s safety-first ratio or the Sharpe ratio
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28
Q

Describe some quantitative methods for evaluating risk tolerance:

  • Mean-variance approach
A
  • maximize risk-adjusted expected return (utility)
  • Risk-adjusted return Um falls as investor risk aversion and/or σ increases
  • Pick the portfolio m with the highest Um
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29
Q

Define the formula for calculating investor utility Um under the mean-variance approach and describe its components

A

Investor utility Um for a given asset mix m (i.e. a portfolio) is given by:

Um = E(Rm) - 0.005RAσ2m

E(Rm) = expected return of asset mix

0.005RAσ2m = “risk penalty”

RA = value of risk aversion

σm = standard deviation of asset mix

Where RA comes from a questionnaire:

  • RA of 6–8: high risk aversion (low risk tolerance)
  • RA of 1–2: low risk aversion (high risk tolerance)
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30
Q

Define shortfall risk

A

Shortfall risk – risk that a portfolio’s value will fall below some minimum acceptable level during a stated time horizon

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31
Q

Describe the “safety-first optimal portfolio”

A

The “safety-first optimal portfolio” maximizes Roy’s SFRatio

SFRatio = (E(RP) - RL)/σP

  • RL = minimum threshold return that the investor insists on meeting
  • If RF > RL, always hold the risk-free asset! (SFRatio = infinity)
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32
Q

What is the relationship between the Sharpe ratio and Roy’s SFRatio?

A

Sharpe ratio = SFRatio using the risk-free rate RF for RL

SharpeRatio = [E(RP) - RF]/σP

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33
Q

Describe the standard normal probability approach for quantifying shortfall risk

A

Standard normal probability approach: choose portfolio with the lowest:

Pr[Rp < RL] = Ø(-SFRatio)

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34
Q

List 3 the behaviorial influences on asset allocation

A
  1. Loss aversion
  2. Mental accounting
  3. Regret avoidance
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35
Q

Describe the behaviorial influences on asset allocation:

  • Mental accounting
A
  • tendency to separate assets into “buckets”
  • Possible solution: multistage strategy or goal-based allocation
    • Optimize within 4 buckets: liquidity, income, capital preservation, and growth
    • Problems: more complex and ignores correlations across portfolios
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36
Q

Describe the behaviorial influences on asset allocation:

  • Regret avoidance
A
  • fear of regret
  • May promote diversification
  • May limit divergence from peers
  • May make investors want to establish risky positions slowly
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37
Q

Describe the behaviorial influences on asset allocation:

  • Loss aversion
A
  • most investors worry about losses more than acquiring gains
  • Possible solution: use a shortfall risk constraint in asset allocation
  • Prospect theory: investors become risk-seekers if faced with a substantial loss
    • Possible solution: ALM
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38
Q

List the criteria for specifying asset classes

A
  • Assets within a class should be relatively homogenous
  • Classes should be mutually exclusive
  • Classes should be diversifying (not highly correlated with other classes)
  • All asset classes ≈ world investable wealth
  • Each class should be able to maintain the portfolio’s liquidity
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39
Q

Describe the considerations for including international assets in an insurer’s portfolio

A
  • Non-domestic classes help make up world investable wealth
  • Add an asset to a portfolio if it results in mean-variance improvement:

SharpeRatioN > SharpeRatioP x Corr(RN,RP)

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40
Q

List and describe special issues for international asset classes

A
  • Currency risk requires exchange rate assumptions
  • Increased correlations in times of stress
  • Emerging market concerns
    • Limited shares available
    • Limits on amount of non-domestic ownership
    • Quality of company information
    • Non-normal returns (makes mean-variance analysis invalid)
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41
Q

List some examples of alternative investments

A
  1. Private equity
  2. Real estate
  3. Natural resource
  4. Hedge funds
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42
Q

What are some concerns when investing in alternative investments?

A
  • Ability to research before investing
  • Lack of information compared to publicly traded assets
  • Higher expenses than traditional asset classes
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43
Q

What are the 4 key activities in the investment management process?

A
  1. Setting the investment objective (return, risk, and constraints)
  2. Developing and implementing a portfolio strategy
  3. Monitoring the portfolio
  4. Adjusting the portfolio
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44
Q

List the 5 strategies for managing against a bond market index, from the least tracking error to most (i.e. passive vs active strategies)

A
  1. Pure bond indexing
  2. Enhanced indexing by matching primary risk factors
  3. Enhanced indexing by small risk factor mismatches
  4. Active management by larger risk factor mismatches
  5. Full-blown active management (most aggressive mismatches!)
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45
Q

Describe the strategies for managing against a bond market index:

  • Enhanced indexing by matching primary risk factors
A
  • Primary risk factors: interest rate level, yield curve twists, and spreads
  • Cheaper than pure indexing and allows opportunity for higher yield
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46
Q

Describe the strategies for managing against a bond market index:

  • Enhanced indexing by small risk factor mismatches
A
  • Match duration, while actively managing smaller risk factors (sector, quality, etc.)
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47
Q

Describe the strategies for managing against a bond market index:

  • Pure bond indexing
A
  • (or full replication)
  • Attempts perfect match (own all bonds in index)
  • Rare: expensive and inefficient
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48
Q

List the 3 reasons for using indexing

A
  1. Lower fees than managed accounts
  2. Outperforming an index (after costs) is difficult to do consistently
  3. Excellent diversification
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49
Q

Describe the risk factors to consider when choosing an index

A
  1. Market value risk of portfolio should be similar to benchmark
    • Longer portfolios tend to have higher MV risk
  2. Income risk should be similar to benchmark
    • Longer portfolios tend to have less income risk
  3. Liability framework risk – should match A/L investment characteristics
    • Use longer bonds for longer liabilities
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50
Q

Describe the 3 risks that a manager should consider when assessing an index’s sensitivity

A
  1. Interest rate risk – changes in level of interest rates (parallel shifts)
    • Largest risk source (90%)
  2. Yield curve risk – changes in yield curve shape (twists, curvature)
  3. Spread risk – changes in spread over Treasuries (credit risk)
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51
Q

List the primary bond risk factors

A
  1. Duration and convexity – price sensitivity to parallel yield shifts
  2. Key rate duration and present value distribution of cash flows
  3. Sector and quality percent
  4. Sector duration and contribution
  5. Quality (credit) spread duration contribution
  6. Sector/coupon/maturity cell weights
  7. Issuer exposure (manage event risk)
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52
Q

What is the tracking risk?

A

standard deviation of the portfolio’s active return over time

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53
Q

Describe the main disadvantage of using enhanced bond management strategies

A

Enhanced strategies add costs ⇒ must be earned on top of a passive return

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54
Q

Describe strategies to overcome the high costs of enhanced indexing

A
  1. Lower cost enhancements – reduce trading costs and management fees
  2. Issue selection enhancements – attempt to find undervalued securities
  3. Yield curve positioning – find consistently mispriced maturities
  4. Sector and quality positioning (2 forms)
    • Tilt toward short corporates (high yield spread per unit of duration risk)
    • Periodic over- or under-weighting of sectors or qualities
  5. Call exposure positioning – e.g. under-weight in callable bonds if you expect falling interest rates
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55
Q

Describe some additional activities that are carried out by active managers

A
  1. Exploit index mismatches (based on manager’s expertise)
  2. Extrapolate market expectations from market data (e.g. analyze forward rates)
  3. Independently forecast inputs and compare with market’s expectations
    • Example: manager may believe forward rates are too high ⇒ increases duration mismatch by increasing portfolio duration
  4. Estimate relative values of securities to identify areas of under- or over-valuation
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56
Q

Define total return with respect to bond returns

A

Total return accounts for coupon income, reinvestment income, and change in price

Semiannual Total Return = (Total Future Dollars/Full Price of Bond)1/n -1

n = total semiannual periods in investment horizon

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57
Q

Describe the benefits of scenario analysis

A
  1. Assess distribution of possible outcomes (wider distribution = more risk)
  2. Reverse scenario analysis: determine the IR movements that would trigger acceptable outcomes
  3. Calculate contribution of individual components (e.g. impact of a yield twist)
  4. Evaluate merits of entire trading strategy
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58
Q

List the 2 types of dedication strategies

A
  1. Immunization – classical single period and 4 extensions
  2. Cash flow matching
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59
Q

4 extensions for immunization

A
  1. Extensions for non-parallel shifts
  2. Relax the fixed horizon requirement
  3. Return maximization (risk and return trade-offs)
  4. Contingent immunization
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60
Q

Describe cash flow matching

A
  • Exact (basic) cash flow matching
  • 2 extensions: symmetric and combination (horizon) matching
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61
Q

List the 2 requirements for classical single period immunization

A
  1. Portfolio duration = liability horizon (duration)
  2. PV of portfolio cash flows = PV of liability cash flows
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62
Q

List the important characteristics of immunization

A
  1. Specified time horizon
  2. Assured rate of return over a fixed holding period
  3. Portfolio value at the horizon date is insulated from interest rate changes
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63
Q

Describe 2 ways that a portfolio’s duration can change

A
  1. As market yields change (convexity effects)
  2. With the passage of time (as the bond approaches maturity)
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64
Q

Define the immunized target rate of return

A
  • Immunized target rate of return = total portfolio return assuming no change in the term structure
    • Will only equal YTM if the yield curve is flat
    • If yield curve is positively sloped, total return < YTM
    • If yield curve is negatively sloped, total return > YTM
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65
Q

Describe the steps required for rebalancing to the desired level of dollar duration

A
  • Calculate the new (or current) portfolio DD
  • Calculate the rebalancing ratio:

(Target DD/New DD) - 1

  • Calculate amount of cash needed for rebalancing:

Rebalancing Ratio x MV of Portfolio

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66
Q

Define spread duration

A

Spread duration = change in price if the yield spread changes by 100 bps

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67
Q

Describe how classical immunization can be extended for non-parallel interest rate shifts

A
  • Key rate duration (a.k.a. “multi-functional duration”)
  • Arbitrary interest rate changes
    • Set portfolio duration = investment horizon
    • Changes in portfolio value depend on:
      • Structure of investment portfolio
      • M2 = immunization risk measure (“maturity variance”)
    • If M2 is small, immunization risk is small
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68
Q

Describe the steps under multiple liability immunization

A
  • Set DA = DL
  • Asset cash flows must “bracket” liability cash flows
    • Shortest asset < shortest liability; longest asset > longest liability
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69
Q

Describe the steps for immunizing general cash flows

A
  1. Assume future assets are a hypothetical investment
  2. Invest available funds to mature beyond liability horizon
    • Portfolio duration should match liability horizon
  3. When the future assets become available:
    • Invest new funds in assets that will mature at the liability horizon
    • Sell existing longer assets and reinvest at the liability horizon
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70
Q

What is the goal of return maximization for immunized portfolios?

A

Goal: maximize the lower bound return given the investor’s risk tolerance

Expected Return +/- 2σ

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71
Q

Describe contingent immunization

A
  • Goal: pursue active management as long as there is a positive safety margin
    • Safety margin = Current Portfolio Value - Min Value Required for Immunization
    • Cushion spread = max(0, i - s)
      • i = available immunized return
      • s = safety net rate of return = required return to reach required terminal value
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72
Q

Describe the sources of liability funding risk

A
  1. Interest rate risk – reinvestment and disintermediation risk
  2. Contingent claim risk (call and prepayment provisions)
    • Call/prepayment features add reinvestment risk
  3. Cap risk (floating rate securities with caps)
    • If market rates > cap, investor loses additional interest and bond behaves like a fixed bond
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73
Q

Describe the importance of reinvestment risk

A

Portfolios with the least reinvestment risk have the least immunization risk

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74
Q

Describe the differences between cash flow matching and multiple liability immunization

A
  • Main problem with cash flow matching:
    • Exact matching is usually not possible
    • Reinvestment will be required ñ liability funding risk
  • Cash flow matching is inferior to multiple liability immunization because it requires:
    1. Relatively high cash balance with a conservative rate of return
    2. Funds available when or before each liability is due
  • Cash flow matching is still used sometimes because it is easy!
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75
Q

List the 2 extensions of basic cash flow matching

A
  1. Symmetric cash flow matching
  2. Combination matching (a.k.a. horizon matching)
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76
Q

Describe the 2 extensions of basic cash flow matching

  • Symmetric cash flow matching
A
  • Borrow short-term money to meet liability
  • Invest in longer assets that will mature after the liability
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77
Q

Describe the 2 extensions of basic cash flow matching

  • combination matching (a.k.a. horizon matching)
A
  • Duration-match portfolio and cash flow match initial years
  • Ensures short-term cash flows are met (e.g. first 5 years)
  • Reduces risk of non-parallel shifts
  • Disadvantage: increases cost of funding liability
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78
Q

List the considerations when applying dedication strategies

A
  1. Universe considerations (credit risk, embedded options, liquidity)
  2. Optimization
  3. Monitoring (periodic performance measurement)
  4. Transaction costs (initial and rebalancing)
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79
Q

Describe 2 combination dedication strategies

A
  • Active/passive combination
    • Large core passive portfolio with smaller actively managed portfolio
  • Active/immunization combination (e.g. contingent immunization)
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80
Q

Define a repo agreement

A
  • Repo – sell a security (e.g. T-bill) and agree to purchase it back (usually the next day)
  • Repo interest = Repurchase Price - Sale Price
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81
Q

What are the characteristics of a repo agreement?

  • Repos offers a low cost way to borrow short-term funds
A
  • Repos offers a low cost way to borrow short-term funds
    • Term to maturity is usually overnight or a few days
    • Can be extended by rolling over
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82
Q

What are the characteristics of a repo agreement?

  • Methods of transferring securities between parties
A
  • Physical delivery (highest cost and usually not practical)
  • Credit and debit accounts with banks (cheaper but still has fees)
  • Deliver to custodial account at seller’s bank (reduces costs)
  • No delivery (OK if parties trust each other)
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83
Q

What are the factors that increase the repo rate?

A
  1. Lower quality collateral (securities being exchanged)
  2. Longer repo term (if upward sloping yield curve)
  3. No physical delivery (higher risk of default)
  4. Collateral is in high supply or easy to obtain (less attractive for buyer/lender)
  5. Higher prevailing interest rates in the economy
  6. Seasonal factors that restrict supply or increase demand for repos
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84
Q

List the 4 non-duration risk measures

A
  1. Standard deviation (or variance)
  2. Semivariance
  3. Shortfall risk
  4. Value at risk (VaR)
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85
Q

Describe the non-duration risk measures and their disadvantages:

  • Semivariance
A
  • measures dispersion of returns below the target return
  • Not widely used: computationally challenging and unreliable for asymmetric returns
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86
Q

Describe the non-duration risk measures and their disadvantages:

  • Shortfall risk
A
  • Does not account for the magnitude of losses
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87
Q

Describe the non-duration risk measures and their disadvantages:

  • Value at risk (VaR)
A
  • estimates the loss at a given percentile
  • does not capture magnitude of losses beyond the specified percentile
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88
Q

Describe the non-duration risk measures and their disadvantages:

  • Standard deviation (or variance)
A
  • useful only if returns are normal
  • Most portfolio returns are not normal
  • The number of variances and covariances becomes very large as the number of bonds n increases:

n(n + 1)/2

  • Bond characteristics change over time
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89
Q

List the products used in derivatives-enabled strategies

A
  1. Interest rate futures and forwards (bond futures)
  2. Interest rate swaps (e.g. fixed for floating)
  3. Interest rate options (calls and puts on physicals or futures, caps)
  4. Credit risk instruments (forwards, spread options, swaps)
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90
Q

Define interest rate futures and forwards

A

Long party agrees to buy a bond from short party in the future at the futures price

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91
Q

Define basis risk

A

Basis = Bond Cash Price - Futures Price

  • Basis risk = risk of unpredictable changes in the basis
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92
Q

Define cross hedging

A
  • Cross hedging – hedged bond not equal to bond underlying the futures contract
    • Increases basis risk
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93
Q

List the 3 major sources of hedging error

A
  1. Incorrect duration
  2. Projected basis
  3. Yield beta
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94
Q

Define an interest rate swap

A

Contract between two parties to exchange periodic interest payments based on a notional principal amount

Interest Payment = Specified Interest Rate x Notional Amount

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95
Q

Define the dollar duration (DD) of an interest rate swap

A

Swap DD = Fixed Rate Bond DD - Floating Rate Bond DD

≈ Fixed Rate Bond DD (since a floater’s duration is very small)

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96
Q

List the 3 ALM applications of swaps

A
  1. Alter asset and liability cash flows
  2. Adjust the portfolio duration
  3. Cheaper/easier alternative to using a package of forward contracts
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97
Q

Define option duration

A

Option Duration = Duration of Underlying

x Option Delta

x (Price of Underlying/Price of Option Instrument)

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98
Q

List 3 ways that hedging can be done with options

A
  1. Buying protective puts – protects against rising interest rates
  2. Selling covered calls – generates premium income on out-of-the-money calls
  3. Interest rate caps, floors, and collars
    • Caps pay off if rates > cap rate; floors pay off if rates
    • Collar = cap + floor
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99
Q

Describe credit spread options

A
  • Credit spread options only pay off if ITM at maturity

Payoff = max[(Spread at Option Maturity - K)

x Notional

x Risk Factor,0]

  • Risk Factor = change in security value per 1 bps change in credit spread
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100
Q

Describe credit forwards

A
  • Credit forwards have similar payoffs to credit spread options, but no downside protection

Payoff = (Spread at Forward Maturity - K)

x Notional

x Risk Factor

*where K = “contracted credit spread”

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101
Q

Describe credit default swaps (CDS)

A
  • Shifts credit risk based on a reference entity from the protection buyer to the protection seller
    • Protection buyer pays regular swap premiums to the protection seller
    • If a defined credit event causes a loss on the reference entity bond, the protection seller pays the loss to the protection buy
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102
Q

List the advantages and uses of CDS

A
  1. Reduce credit risk concentration without selling or shorting assets
  2. Hedge non-publicly traded debts
  3. Protection seller does not have to make an upfront investment
  4. Can be tailored to specific needs since over-the-counter
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103
Q

Define internal cash flows and external cash flows

A
  • Internal cash flows = dividends, interest payments, etc. generated within the account
  • External cash flows = contributions and withdrawals made to/from an account
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104
Q

Define the total rate of return

A

Total rate of return includes realized and unrealized capital gains in addition to income

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105
Q

Describe the time-weighted rate of return (TWR)

A

TWR = compound growth rate of $1 initially invested in the account

*Must be calculated every time an external cash flow occurs

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106
Q

Describe the money-weighted rate of return (MWR)

A

MWR = average compound growth rate of all money invested in an account (IRR)

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107
Q

Describe the linked internal rate of return (LIRR)

A

LIRR blends advantages of TWR and MWR

  1. Calculate MWR over reasonably frequent time intervals
  2. Chain-link the MWRs over the entire evaluation period

Remember that MWR is just an IRR (hence the name linked IRR)

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108
Q

Describe the relationship between linked IRR and time-weighted return

A

LIRR is an acceptable proxy for TWR unless there are unusual circumstances

  • “Unusual” = large external cash flows (10%+ of AV) and/or volatile account growth
  • Conclusion is based on a BAI study of monthly valuations and daily cash flows
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109
Q

List 2 data quality issues when calculating rate of returns

A
  1. Reported rates of return are only as accurate as their inputs
  2. Reliable performance measures also require appropriate data collection procedures
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110
Q

Describe some data quality issues when calculating rate of returns

  • Reported rates of return are only as accurate as their inputs
A
  • Liquid, transparently priced securities have the most reliable returns
  • Thinly traded securities – could use matrix pricing
    • Estimate prices using dealer-quoted prices for similar securities
  • Highly illiquid securities – carry at cost or price at last trade
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111
Q

Describe some data quality issues when calculating rate of returns

  • ​Reliable performance measures also require appropriate data collection procedures
A
  • Report on a trade-date, fully accrued basis
  • Reflect impact of unsettled trades and income owed but not paid
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112
Q

Define the conventional yield measure current yield

A

Current yield – only measures coupon income

Current Yield = Annual Dollar Coupon Interest/Price

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113
Q

Define the conventional yield measure yield-to-maturity (YTM)

A
  • Yield-to-maturity (YTM) = IRR such that PV(Cash Flows) = Price (or Initial Investment)
    • Typically expressed on a BEY basis (nominal semiannual)
    • Portfolio IRR can be calculated by combining all bond cash flows
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114
Q

Define the conventional yield measure yield-to-call (YTC)

A

Yield-to-call (YTC) – like YTM but using a call date

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115
Q

Define total return

A

Total Return (a.k.a. horizon return) – rate that accumulates full price and coupons to projected total future dollars at end of horizon

Semiannual Total Return = (Total Future Dollars/Full Price of Bond) 1/n -1

n = number of semiannual periods

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116
Q

Describe the significance of interest-on-interest

A
  • Can be very significant (up to 80% of total return)
  • If reinvestment rates are less than YTM or YTC, total return < YTM or YTC
  • Characteristics that increase exposure to reinvestment risk:
    • Longer maturity dates
    • Higher coupons
  • Zero-coupon bonds have no reinvestment risk if held to maturity
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117
Q

Describe Yield-to-Call

A
  • YTC = yield if bond is held until called at either
    • First call date – the date at which the bond can be called
    • First par call date – the date at which the bond can be called at par
  • Conservative investors will use min(YTM, YTC) for callable bond selling at a premium
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118
Q

Describe yield-to-worst

A
  • Yield-to-worst – the lowest possible YTC for any possible future call date
    • Most conservative measure for a callable bond
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119
Q

Describe problems that are common to both yield-to-call and YTM

A

Problems common to both YTC and YTM:

  1. Assumes coupons reinvested at YTC
  2. Assumes investor will hold the bond to the assumed call date
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120
Q

Describe problems that are specific to YTC

A

Problems specific with YTC:

  1. Can’t reflect reinvestment of proceeds at call date
  2. Assumes the issuer actually calls the bond at call dates
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121
Q

Describe a floating-rate bond

A

A floating-rate bond’s coupon fluctuates with a reference rate Rt

Coupont = (Rt + Spread) x Par

Therefore, the coupon values are unknown

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122
Q

Define discount margin with respect to a floating-rate bond

A

Discount margin = estimated average spread over the reference rate for the life of the security

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123
Q

Describe the steps to determine the discount margin

A

If selling at a premium or discount:

  1. Determine future cash flows assuming the reference rate never changes
  2. Select a margin (spread)
  3. PV the Step 1 cash flows at a discount rate equal to the reference rate + the spread in Step 2
  4. Compare Step 3 to the price
    • If the Step 3 PV = price: discount margin = Step 2 spread
    • Else, try a different spread in Step 2 and repeat
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124
Q

Describe how to evaluate potential bond swaps

A
  1. Pure yield pickup swap – replace a low-yield bond with a higher yield bond
  2. Rate-anticipation swap – takes advantage of an expected move in interest rates
  3. Intermarket-spread swap – undertaken if manager believes yield spreads are mispriced by market
  4. Substitution swap – swapping bonds with identical features to get a bond with higher yield
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125
Q

Define taxable equivalent yield

A

Taxable equivalent yield = yield on a taxable bond that makes it equivalent to a tax-exempt bond

Taxable Equivalent Yield = (Tax-Exempt Yield)/(1 - Marginal Tax Rate)

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126
Q

List 2 problems with taxable equivalent yield and a possible solution

A

Problems with taxable equivalent yield:

  1. Same limitations as YTM
  2. Taxable and tax-exempt bonds have different reinvestment opportunities
    • Only the coupon after taxes can be reinvested for a taxable bond
    • The full coupon of a tax-exempt bond can be reinvested

Solution: reflect changing tax rates in total return scenario analysis

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127
Q

Define liquidity risk

A

Liquidity risk – risk that cash sources are insufficient to meet cash needs under current market conditions or possible future environments

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128
Q

Define the liquidity coverage ratio

A

Liquidity Coverage Ratio = Cash Sources/Cash Needs

(should be >= 100%)

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129
Q

List 5 cash sources

A
  1. Cash inflows from products (premiums, deposits)
  2. Asset cash flows (investment income and maturities)
  3. Sales of assets
  4. Contingent sources
    • Ability to monetize illiquid assets (e.g. real estate)
    • Uncommitted LOCs and standby/back-up liquidity lines
    • Ability to issue new product on a guaranteed basis
  5. Repos and securities lending
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130
Q

List 3 cash needs

A
  1. Cash outflows from products (benefits, withdrawals)
  2. Operating cash outflows
  3. Contingent cash needs arising from environmentally-driven factors
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131
Q

List the 7 principles of liquidity risk management

A
  1. Liquidity risk is an asset/liability concern
  2. Set liquidity risk tolerance using both qualitative and quantitative tools
  3. Consider liquidity costs when designing products and asset portfolio
  4. Incorporate liquidity in SAA (cash flow uncertainty, stress tests)
  5. Manage access to financial markets and funding channels
  6. Written liquidity policy
  7. Written liquidity stress management plan approved by senior management
132
Q

Describe the contents of a liquidity policy

A
  1. Definition of liquidity adequacy
  2. Degree of reliance on external cash sources vs. self-funding
  3. Minimum standards to be adequately protected from liquidity risk
    • “Cure periods” if standards are not met
    • Demonstrate with stress testing
    • Report violations to senior management quickly
  4. Frequency of liquidity adequacy measurement
  5. Key responsibilities for strategy, risk limits, reporting, and monitoring
  6. Requirements for liquidity crisis planning
133
Q

Describe the purpose and use of a liquidity stress management plan

A
  • Approved by senior management
  • Designate a liquidity crisis management team
    • Convene when a crisis occurs
    • First task: assess severity
    • Send directives to investment and product managers
  • Manage internal/external communications during a crisis
    • Avoid sending the wrong message to rating agencies, etc.
    • Appoint a single company contact for external audiences
  • Perform regular drills to assess effectiveness of contingency plans
134
Q

List types of liquidity stress tests

A
  1. Disintermediation scenario
  2. Catastrophic claims scenario
  3. Customer panic scenario
  4. Impaired markets scenario
  5. Impaired markets/panic withdrawal scenario
135
Q

Describe types of liquidity stress tests and their respective considerations

  • Customer panic scenario
A
  • Impact of falling equity markets, rising credit spreads, and/or cat losses
  • Assume full withdrawals fixed deferred annuities
136
Q

Describe types of liquidity stress tests and their respective considerations

  • Impaired markets/panic withdrawal scenario
A
  • “run on the book”
  • Very difficult to manage if capital market liquidity has vanished
  • Requires access to other external cash sources
137
Q

Describe types of liquidity stress tests and their respective considerations

  • Impaired markets scenario
A
  • capital markets become frozen for 3–6 months
  • Impossible to sell assets during this time
138
Q

Describe types of liquidity stress tests and their respective considerations

  • Catastrophic claims scenario
A
  • simulate a catastrophic event
  • Consider interdependency between capital markets and catastrophes
  • Mitigate with diverse products and reinsurance cash loss clauses
139
Q

Describe types of liquidity stress tests and their respective considerations

  • Disintermediation scenario
A
  • e.g. shock interest rates +300 bps
  • Surrenders rise, asset MVs fall, callable bonds/MBS extend
  • Highest risk products: deposit-based contracts sold to high net worth clients
  • Highest risk channels: financial advisors, brokers, and banks
140
Q

Describe liquidity risk in policyholder funds

A
  • Liquidity risk can also be born by policyholders (e.g. separate account products)
  • Creates operational risk for the insurer
    • Insurer should adequately disclose investment risks
    • Insurer has a fiduciary responsibility to suspend withdrawals in “run” scenarios to protect all policyholders
141
Q

Who is the investment actuary

A

liaison between product actuaries and portfolio managers

142
Q

Describe how an investment actuary adds value

A
  1. Helps product actuaries / senior management (objectives, product design)
  2. Develops policies for liquidity, ALM, investments, and derivatives
  3. Provides product information to investment advisor
  4. Helps set crediting rates
  5. Coordinates cash levels with Treasury department
  6. Advises portfolio manager on accounting/product constraints on specific trades
  7. Allocates new securities to asset segments
  8. Leads A/L modeling (scenario analysis, duration, hedging)
  9. Coordinates investment return effect on financial statements / policy values
143
Q

Describe the short-term investment process the investment actuary should be aware of

A
  • The Treasury area maintains sweep accounts operating cash flow
    • Premiums/fees go in, benefits/expenses go out
  • Substantial excess funds should transferred to investment accounts
  • Invest cash from highly sensitive rate quotes ASAP
  • Must determine how to allocate cash between surplus and product segments
    • Can be very complex
144
Q

Describe the long-term investment process, under the general guidance approach

A
  1. Set a target mix for new purchases
  2. Update mix quarterly (or more frequently) based on the plan’s projected income
  3. Actively sold products: build a robust, diversified portfolio
  4. Products in runout: build an adequately liquid, high cash flow portfolio
145
Q

Describe the long-term investment process, under specific guidelines

A
  • Determine product funding needs more frequently
  • Target funding level = last month’s liability valuation plus net product cash flow
    • May include required surplus, too
  • Capital planning is necessary
146
Q

List considerations when deciding between the general guidance approach and specific guidelines

A
  1. Level of cash flow
  2. Asset risks inherent in the investment strategies
  3. Investment advisor’s expertise in the products your company sells
  4. Management’s comfort level with the investment advisor
  5. Detail available from general ledger (including electronic availability)
147
Q

Compare the realities of trading stocks vs. bonds

A
  • Round lot = standard trade size
    • Stocks: 100 shares
    • Bonds: $1 million
  • Stock trading is more streamlined, efficient
  • Bond market is dominated by institutional investors (due to large lot sizes)
  • Bonds are generally less liquid
  • Bond trading requires much more negotiation
    • “Can be like a poker game”
148
Q

List 4 constraints on asset sales

A
  1. Accounting
  2. Embedded value / economic value added
  3. Asset/Liability Management
  4. Credited rates and policyholder equity
149
Q

Describe constraints on asset sales:

  • Credited rates and policyholder equity
A
  • Selling a high-yielding bond can hurt crediting rates
  • Constraints on credit quality, maturity structure, or concentration
150
Q

Describe constraints on asset sales:

  • Asset/Liability Management
A
  • Bond prices usually increase before upgrades
  • Riding the yield curve — unrealized gains emerge as bond approaches maturity
151
Q

Describe constraints on asset sales:

  • Embedded value / economic value added
A
  • Impact is usually minimal
152
Q

Describe constraints on asset sales:

  • Accounting
A
  • Stat accounting spreads gains and losses over life of original assets (IMR and AVR)
  • Realized gains are taxable
153
Q

List 6 items to include in an insurer’s investment policy

A
  1. Investment Objectives
  2. Investment Constraints
  3. Scope
  4. Authority from the Board of Directors
  5. Investment Committee
  6. Appendices
154
Q

List 6 items to include in an insurer’s ALM policy

A
  1. Objectives
  2. Ground rules
  3. Guidelines and tolerances
  4. Process
  5. Reporting
  6. Governance
155
Q

List 6 items to include in an insurer’s derivatives policy

A
  1. Accountability
  2. Permitted uses
  3. Types of derivatives permitted
  4. Counterparties
  5. Derivative portfolio exposure limits
  6. Internal controls
156
Q

List 5 items to include in an insurer’s liquidity policy

A
  1. Objectives
  2. Management oversight
  3. Liquidity measures and reports
  4. Constraints
  5. Written plan
157
Q

List the 3 different types of securities issued by the U.S. Treasury

A
  1. Discount securities
  2. Coupon securities
  3. Treasury Inflation-Protected Securities (TIPS)

*Treasury notes account for the vast majority outstanding

158
Q

Describe the different types of securities issued by the U.S. Treasury:

  • Treasury Inflation-Protected Securities (TIPS)
A
  • Principal is inflation-adjusted by CPI
  • Coupons = fixed % of inflation-adjusted principal
159
Q

Describe the different types of securities issued by the U.S. Treasury:

  • Coupon securities
A
  • “Notes” have 2–10 year maturities
  • “Bonds” have maturities > 10 years
160
Q

Describe the different types of securities issued by the U.S. Treasury:

  • Discount securities
A
  • (no coupons)
  • T-bills have a maturity <= 1 year
161
Q

Describe the primary market auction process

A
  1. Sold through sealed-bid, single-price auctions
  2. Open to primary and non-primary dealers
    • Primary dealers interact directly with the NY Fed
  3. Treasury accepts competitive bids from lowest to highest yield
    • Stops accepting when total issue (less noncompetitive bids) gets filled
    • Stop-out yield – highest yield accepted
  • Auctions are held on regular, predictible schedules
  • Treasury also exercises reopenings and buybacks
    • Reopening – additional offering of a security that is already outstanding
    • Buyback – when the Treasury buys outstanding Treasuries in the secondary market
162
Q

List 2 differences between how Treasury Bills are quoted and standard return
measurements

A

Differs from standard return measures in two ways:

  1. Compares dollar return with face value instead of price
  2. Annualized using a 360-day year instead of 365

Bid/ask spreads range from 0–2 bps (tightest for actively traded issues)

163
Q

Describe how “Zeros” and “Strips” are created

A

Created by stripping coupons and principal from issued Treasury securities

  • Not issued directly by the Treasury

STRIPS – Separate Trading of Registered Interest and Principal Securities

  • Created by the Treasury in 1985 to improve liquidity of strips
  • Allows strips to be registered separately with the Federal Government
164
Q

Describe the credit quality of agency securities

A

Agencies trade at a slight discount to Treasuries, which reflects:

  • Strength of each agency’s underlying business
  • Perceived government backing (boosted by actions in the 2008 crisis)
  • Liquidity differences with Treasuries
165
Q

Why are agencies attractive to investors?

A

Agencies are attractive to investors who want:

  1. Slightly higher returns than Treasuries due to slightly higher credit risk
  2. Interest income (sometimes exempt from state and local taxes)
166
Q

List the 3 different types of agency securities

A
  1. Short-dated
  2. Longer-dated
  3. Callable agencies
167
Q

Describe the 3 different types of agency securities:

  • Longer-dated
A
  • (1–30 years)
  • pay semiannual coupons, priced like T-notes
  • Medium term notes (senior/subordinated, callable/putable, fixed/floating, etc.)
  • Step-up notes – issuer can call at specific dates; else investor’s interest rate rise
168
Q

Describe the 3 different types of agency securities:

  • Callable agencies
A
  • (significant)
  • Helps manage mortgage prepayment risk from falling interest rates
  • Yield more than non-callable bonds
  • Main characteristics
    • Maturity date – latest maturity date if not called
    • Lockout period – initial period before agency can call
    • Type of call: European, Bermudan, American
169
Q

Describe the 3 different types of agency securities:

  • Short-dated
A
  • (1–365 days)
  • “discount notes” priced like T-bills
170
Q

Describe the primary agency market

A

The Primary Market

  • Discount note auctions (short-dated notes)
  • Reverse inquiries (all types) – investors can offer at “window rates”
    • Can result in non-standard issues (less liquid in secondary market)
  • Syndicated offerings (large, long-dated securities) – groups of dealers
171
Q

Describe the secondary agency market

A

The Secondary Market

  • Multiple dealer, OTC (similar to Treasuries)
  • Mostly discount notes
172
Q

Describe 3 properties of municipal bonds

A
  1. Issued by states, local governments, and other public entities
  2. Usually purchased for their tax-exempt status
    • Individual and institutional investors (e.g. insurers)
    • Crossover buyer – taxable bond investor that sometimes buys tax-exempt
  3. Credit risk has increased in recent history
173
Q

Describe 4 features of municipal bonds

A
  1. Coupons can be fixed, floating, or inverse floating
  2. Some are issued originally at a discount to par (OIDs)
  3. Serial bonds are common (multiple maturities per issue), but also term bonds
  4. Legal opinion required to certify:
    • Issuer is legally able to issue the bonds
    • Issuer has followed all laws for tax exempt status
    • Security safeguards by 3rd parties are supported by law
174
Q

List reasons why credit risk for municipal bonds has been increasing

A
  • Major municipal failures (e.g. Orange County)
  • Bankruptcy protection for issuers
  • Innovative/untested structures
  • Cutbacks in municipal funding
  • Adverse economic changes affecting municipalities
175
Q

List 5 types of municipal bonds

A
  1. General obligation bonds
  2. Revenue bonds
  3. Hybrid and special bond securities
  4. Money market products
  5. Municipal derivatives
176
Q

Describe types of municipal bonds:

  • Municipal derivatives
A
  • instruments created from municipals
  • Floaters, inverse floaters, tender option bonds
177
Q

Describe types of municipal bonds:

  • Money market products
A
  • Notes (12-mo), commercial paper, VRDOs, commercial paper mode
178
Q

Describe types of municipal bonds:

  • Hybrid and special bond securities
A
  • Least risky: refunded bonds have security held in escrow
  • Others: dedicated tax-backed, lease-backed, LOC-backed, etc.
179
Q

Describe types of municipal bonds:

  • Hybrid and special bond securities
A
  • Least risky: refunded bonds have security held in escrow
  • Others: dedicated tax-backed, lease-backed, LOC-backed, etc.
180
Q

Describe types of municipal bonds:

  • Revenue bonds
A
  • backed by revenue from specific projects
181
Q

Describe types of municipal bonds:

  • General obligation bonds
A
  • secured by taxing powers
  • Full faith and credit obligations vs. limited-tax GOBs
182
Q

What are the factors affecting valuation of a municipal bond?

A
  • maturity
  • offered price
  • call features
  • sinking funds
  • credit quality
183
Q

Describe valuation methods for municipal bonds

A
  • based on the yield-to-worst plus nominal credit spread that reflects the credit quality
  • should be compared to the yield on a taxable bond by computing an equivalent taxable yield for the municipal bond
  • if the municipal bond is trading at a discount to par, the numerator should be adjusted for capital gains taxes
184
Q

Formula for an equivalent taxable yield for a municipal bond

A

Taxable Equivalent Yield = (Tax-Exempt Yield)/(1 - Marginal Tax Rate)

185
Q

What are the drawbacks of the traditional valuation methodology for municipal bonds?

A
  • Ignores the effect of tax rates on reinvested coupons
  • YTW assumes static interest rates
  • Actual cash flow timing may differ from expected
  • Future cash flows depend heavily on if/when bond is called
186
Q

Describe the legal relationship between a corporate bond issuer and the bondholders

A

Indenture – complicated contract between the bond issuer and bondholders

Corporate trustee – bank or trust company that acts as a fiduciary for the investors

  • Paid by the issuer
  • Enforces bondholders’ interests in indenture
  • Can declare default if issuer breaches indenture
187
Q

Describe the fundamentals of a corporate bond

A
  • Issuers: utilities, transportation cos., industrial, banks, etc.
  • Maturity is typically less than 30 years
  • Most are registered or book entry: pay automatic coupons
  • Straight coupon bonds: pay fixed coupons semiannually
    • Participating bonds share profits over a certain level
    • Income bonds (rare) only pay interest if issuer’s income is high enough
  • Coupons may also be zero, deferred, or paid-in-kind (PIK)
188
Q

Describe the following coupon types:

  • Deferred-interest bond (DIB)
A
  • A type of OID bond
  • Less popular today (tax benefits have declined)
  • No reinvestment risk if held to maturity
  • higher credit risk than straight coupon bonds
189
Q

Describe the following coupon types:

  • Pay-in-kind (PIK) debentures
A
  • Pays additional pieces of security instead of coupons
  • Additional securities can be sold separately
  • higher credit risk than straight coupon bonds
190
Q

Describe the following coupon types:

  • Zero
A
  • A type of OID bond
  • Less popular today (tax benefits have declined)
  • No reinvestment risk if held to maturity
  • higher credit risk than straight coupon bonds
191
Q

List 5 different types of securities for bonds

A
  1. Debentures
  2. Mortgage Bonds
  3. Collateral Trust Bonds
  4. Equipment Trust Certificates
  5. Guaranteed Bonds
192
Q

Describe the different types of securities for bonds:

  • Guaranteed Bonds
A
  • guaranteed by one or more other companies
193
Q

Describe the different types of securities for bonds:

  • Equipment Trust Certificates
A
  • issued by railroads
  • Trustee owns RR equipment, leases to RR, then RR buys equipment at end of lease
  • Very secure since RR heavily depends on equipment and always buys back
194
Q

Describe the different types of securities for bonds:

  • Collateral Trust Bonds
A
  • backed by stock of issuer’s subsidiaries
  • B/H protection: if issuer defaults, it forfeits voting rates on subsidiary stock
195
Q

Describe the different types of securities for bonds:

  • Mortgage Bonds
A
  • gives B/H a 1st-mortgage lien on property backing bond
  • Blanket mortgage – allows issue of additional series of bonds on the same mortgage
  • Possible B/H protection: after-acquired clause
196
Q

Describe the different types of securities for bonds:

  • Debentures
A
  • no specific security pledged (most common)
  • Bondholders = general creditors (security = financial strength of issuer)
  • Common issuer restrictions: min net worth, selling major assets, stock dividends
  • Other B/H protections: negative pledge clause
  • Subordinated issues may offer conversion rights
197
Q

List 5 methods to retire debt before maturity

A
  1. Call and refunding provisions
  2. Sinking fund provisions
  3. Maintenance and replacement funds (doesn’t retire bonds)
  4. Redemption through sale of assets (usually restricted)
  5. Tender offers – issuer buys back bonds based on PV at CMT + fixed spread

The first 4 must be included in the indenture if applicable

198
Q

Describe corporate bond call provisions

A
  • Riskiest for bondholders: fixed price call provision
    • Call price usually starts at a premium, then declines
    • May have initial lockout period or initial non-refundable period
  • Less risky and more common: make-whole call provision
    • Call price = max(par, PV remaining CFs at CMT + spread)
    • Call price moves inversely with interest rates
    • Issuer advantage: can issue at a lower yield
199
Q

Describe sinking fund provisions

A
  • Popularity has declined
  • Indenture requires issuer to retire a portion of bonds each year (usually at par)
  • Lowers default risk
  • Bondholders benefit if interest rates rise (they get par even if MV < par)
  • Issuer may be able to accelerate sinking fund if interest rates fall
200
Q

Define issuer default rate

A

Issuer default rate – based on number of defaulting issuers

=No. Issuers that Default in the Year/Total Issuers at BOY

201
Q

Define dollar default rate

A

based on amount of defaulted par

202
Q

Express dollar default rate as an annual default rate

A

=Cumulative $ Value of All Defaulted Bonds/Cumulative $ Value of All Issues

203
Q

Express dollar default rate over a certain # of years

A

=Cumulative $ Value of All Defaulted Bonds/

(Cumulative $ Value of All Issues x Weighted Avg. No. Years Outstanding)

204
Q

Define default loss rate and recovery rates

A

Default Loss Rate = Default Rate - Recovery Rate

Recovery rate = % of defaulted bond that bondholders recover after default

  • Difficult to measure historically: consists of cash and securities
205
Q

Define event risk

A

Event risk – risk that a stockholder-driven event results in lower bond prices

  • Rating downgrades, increased leverage, etc. can result from M&A, etc.
206
Q

Define headline risk

A

Headline risk – risk of bad media coverage that results in lower bond prices

207
Q

Give 3 unique features of high-yield bonds

A
  • A.k.a. “junk bonds,” but many are only just below investment grade ( BBB or Baa)
  1. Deferred Coupon Structures (3 kinds)
  2. Extendible Reset Bonds
  3. Clawback
208
Q

Describe unique features of high-yield bonds

  • Deferred Coupon Structures (3 kinds)
A
  1. Deferred-interest bonds (most common) – no coupons for 3–7 years
  2. Step-up bonds – low coupon rate in initial period, then later increases
  3. Payment-in-kind (PIK) bonds
209
Q

Describe unique features of high-yield bonds

  • Extendible Reset Bonds
A
  • Coupon rate resets periodically to keep the bond at a specified price
  • New rate reflects the new interest rate level and credit spread
  • Different from a floating rate bond, which is based on a fixed spread
  • In practice, issuer may not be able to afford the coupon
210
Q

Describe unique features of high-yield bonds

  • clawback (high-yield bond)
A
  • redemption of bonds during a non-callable period with IPO proceeds
  • Can hurt bondholders since their investment would be rising
211
Q

List 5 properties of commercial paper

A
  1. Short-term (e.g. 45 days), unsecured, promissory notes
  2. Issued by domestic and foreign corporations
  3. Exempt from SEC registration (if <270 days)
  4. Mainly sold in primary market
  5. Priced like T-bills, but yield is higher
212
Q

Describe repurchase agreements (“repos”)

A

Borrower “sells” an asset for cash and agrees to repurchase the asset in the future

213
Q

Give 5 characteristics of repurchase agreements (“repos”), including the key parties and market participants

A
  1. Cheaper than borrowing from a bank (since it’s secured)
  2. Can be used to manage short-term liquidity and even leveraged investing
  3. Common borrowers: thrifts and banks
  4. Common lenders: MM funds, municipalities, corporations
  5. The Fed uses repos to implement monetary policy
214
Q

Describe 2 ways of reducing repo credit risk (for the lender)

A
  1. Require a positive margin = value of collateral amount loaned
    • Generally 1% to 3% of amount loaned
  2. Mark collateral to market in 1 of 2 ways:
    • Margin call – borrower must put up more collateral if margin is too low
    • Repricing – borrower has to pay back cash to restore margin
215
Q

List 3 ways of delivering repo collateral

A
  1. Physical delivery (not common)
  2. Hold in a segregated account
  3. Transfer to lender’s custodial account at borrower’s clearing bank
216
Q

Define the repo rate

A
  • Repo rate = interest rate agreed on between the borrower and lender

Dollar Interest = (Dollar Principal) x (Repo Rate) x (Repo Term/360)

217
Q

What are the 4 determinants of the repo rate

A
  • Quality (higher quality → lower rate)
  • Term (varies with yield curve)
  • Delivery requirement (if delivery is required → lower rate)
  • Availability of collateral (if difficult to obtain → lower rate)
    • Lenders will lend at lower rates to get scarce collateral
218
Q

Describe 4 properties of the Federal funds market

A
  1. Banks are required to maintain reserves with the Fed
  2. Banks borrow/lend among themselves to maintain reserves
  3. Federal funds rate = equilibrium fed funds lending rate
    • Heavily influences entire money market, including repo rates
  4. Repo rates < fed funds rate since fed funds lending is unsecured
219
Q

Describe the components of a pure floater’s coupon

A

Pure floater – a floater without embedded options (cap, floor, call, put)

Coupon Rate = Reference Rate +/- Quoted Margin

Common reference rates: LIBOR and T-bill yields

220
Q

Describe a quoted margin in the context of a pure floater’s coupon

A

Quoted margin reflects the market’s view on risk at issue

  • If the required margin > quoted margin, trades at a discount (else premium)
221
Q

Define an inverse floater

A

Inverse floater coupons move inversely with the reference rate K

= K - L x (Reference Rate)

222
Q

Describe 2 reasons why the issuer would exercise the call option on a floater

A
  1. Interest rates fall a lot (fixed-rate debt is more attractive)
    • Especially if floor is active
  2. Required margin (could reissuer cheaper floater)
223
Q

Describe 2 reasons why the bondholder would exercise the put option on a floater

A
  1. Interest rates have risen a lot (fixed-rate bonds are more attractive)
    • Especially if cap is active
  2. Required margin > quoted margin
224
Q

Describe how to create floaters from fixed rate bonds (give formulas)

A

Floaters and inverse floaters can be created from fixed-rate bond “collateral”

Fixed Bond MV = Floater MV + Inverse Floater MV

Fixed Coupon = Floater Coupon + Inverse Floater Coupon

Fixed Bond Duration = (MVFDF + MVIFDIF)/Fixed Bond MV

225
Q

Describe the interest rate risk implications of creating floaters from fixed rate bonds

A
  • Floater duration is very small (low interest rate sensitivity)
  • Therefore inverse floater duration will be high (to balance to collateral)
  • As interest rates fall, IF value increases from 2 effects:
    • Increasing coupons
    • Lower discount rates
226
Q

List 4 spread measures for evaluating floaters

A
  1. Simple Margin
  2. Adjusted Simple Margin
  3. Adjusted Total Margin
  4. Discount Margin
227
Q

Describe spread measures for evaluating floaters:

  • Discount Margin
A
  • Calculates the average expected spread over the life of the floater
228
Q

Describe spread measures for evaluating floaters:

  • Adjusted Total Margin
A
  • No. 2 plus interest earned by investing difference in floater’s par and the carry-adjusted price
229
Q

Describe spread measures for evaluating floaters:

  • Adjusted Simple Margin
A
  • a.k.a. Effective Margin
  • No. 1 adjusted for “cost of carry” if borrowed funds are used
230
Q

Describe spread measures for evaluating floaters:

  • Simple Margin
A
  • a.k.a. Spread for Life
  • Accounts for amortization of discount/premium in addition to quoted margin
231
Q

List 3 price volatility characteristics of floaters

A
  1. Longer time between coupon reset dates
    • Causes floater to behave more like a fixed-rate bond
  2. Decrease in market’s required margin
    • Varies with competitive funding, credit, embedded options, and liquidity
  3. Cap or floor is reached
    • Causes floater to behave like a fixed-rate bond

Note: These are factors that increase a floater’s price volatility

232
Q

Describe 4 portfolio strategies using floaters

A
  1. ALM – back short-term liabilities with floaters
  2. Risk arbitrage strategies – buy floater with cheaper borrowed funds
  3. Betting on changes in required margin
  4. Swap arbitrage – enter a pay-fixed-for-floating swap that earns higher yield than comparable floater
233
Q

Describe the payment characteristics of a mortgage

A
  • Can be amortizing (principal and interest), IO, and/or balloon
  • Rate can be fixed, adjustable (ARMs), or hybrid ARMs
    • ARMs require payment to be recast when the index-based rate changes
234
Q

Describe the loan underwriting process (mortgages)

A
  • Underwriter evaluates borrower’s credit and value of property
  • Criteria used to evaluate credit:
    1. Credit (“FICO”) scores: 730+ is strong
    2. If LTV ratio ¡ 80%, mortgage insurance required
    3. Debt-to-income ratio criteria (lower is better) (e.g. front ratio and back ratio)
  • Documentation/standards declined until the 2008 crisis, then got stronger
235
Q

Back debt-to-income ratio

A

=Front Ratio + (Other Debt Payments Like Auto Loans / Borrower’s Pretax Monthly Income)

236
Q

Front debt-to-income ratio

A

=Total Monthly Payments on the Home / Borrower’s Pretax Monthly Income

237
Q

Describe the relationship between interest rates, prepayment, and duration

A
  • Falling interest rates: prepayments increase, durations decrease
  • Rising interest rates: prepayments decrease, durations increase (“extension”)
238
Q

List 5 items that impact mortgage prepayment risk

A
  1. Sale of property
  2. Destruction of property (e.g. fire)
  3. Borrower default
  4. Partial principal prepayments
  5. Refinancing

*Prepayments can be rate-sensitive or rate-insensitive

239
Q

Define the following measures of prepayment speeds

  • PSA Model
A
  • reflects that CPRs are not constant over the life of the loan
    • Assumes CPR increases by 0.2% per month until it hits 6.0% in month 30
    • Can express in multiples
240
Q

Define the following measures of prepayment speeds

  • Conditional Prepayment Rate (CPR)
A

= annualized SMM

=1 - (1 - SMM)12

CPR = [Scheduled Balance - Actual Balance]/Schedule Balance

241
Q

Define the following measures of prepayment speeds

  • Single Monthly Mortality (SMM)
A

SMM = [Scheduled Balance - Actual Balance]/Schedule Balance

242
Q

List 5 characteristics used to evaluate mortgage credit risk

A
  1. Credit scores
  2. LTVs
  3. Number of days delinquent
  4. Default (90+ days delinquent)
  5. Default loss severity
243
Q

What factors increase default loss severity (mortgage credit risk)?

A
  • High LTV
  • Appraisal values exceed market values
  • Property values decline after origination
  • Foreclosure process is expensive
244
Q

How do agencies and non-agencies handle defaults for mortgages?

A
  • Some agencies insure (Ginnie Mae)
  • Non-agency recoveries depend on foreclosure process
245
Q

List 6 trading characteristics of MBS

A
  1. Traded one month forward
  2. Mortgage roll market facilitates CMO settlement
  3. Most trades are on a TBA basis, but can also be specified pool
  4. Delay = time between mortgage payments and investor receipt
  5. Interest accrues from day 1 of the month on a 30/360-day basis
  6. Delivery standards
    • 0.01% of principal variance allowed for sellers
    • Number of pools per delivery limited by regulation
246
Q

List 4 non-refinancing sources of prepayments

A
  1. Turnover – borrowers move for work and personal reasons
    • Establishes a base prepayment rate
  2. Defaults – effectively a prepayment because of agency guarantees
  3. Health of housing market
  4. Economic cycle
247
Q

List 4 non-interest rate driven refinancing sources of prepayments

A
  1. Cash-out refinancing
  2. Credit curing – refinancing after borrower’s credit has improved
  3. Aging – prepayments ramp up with loan age
  4. Seasonality – prepayments are fastest in summer
248
Q

List 4 interest rate driven refinancing sources of prepayments

A
  1. Level of interest rate (biggest factor)
  2. Loan size – large loans are more likely to refinance
  3. Burnout – refi rates taper off after interest rates fall
  4. Yield curve shape
    • Steep: refi to short loans
    • Flat: refi to lock in long rates
249
Q

Describe 4 MBS spread measures

A
  1. Static spread = MBS Yield 10-Year Treasury Yield
  2. Interpolated WAL spread = MBS Yield Treasury With Similar WAL
  3. Zero spread = constant spread over zero-coupon Treasury rates such that PV(CFs) = MBS price
  4. OAS – like No. 3 but using Monte Carlo to caption embedded options
250
Q

Briefly describe the CMO market

A
  • Created from MBS (pass-throughs), which consists of residential mortgages
  • Issued by agencies and non-agencies
  • Very large, liquid market similar to corporate bonds
  • Tranche = class/bond/security created within a CMO
  • Some tranches receive principal (or interest) before others
251
Q

List 4 primary “flavors” of sequentials and PACs

A
  1. Sequential classes receive collateral principal in order
  2. PACs receive a schedule of principal based on a PSA band
  3. Support bonds absorb excess prepayments/extension to keep PACs on schedule
  4. PAC 2 (extra support class between a PAC and support bonds)
252
Q

Describe the 5 properties of sequential deals or (“Vanilla Bonds”)

A
  1. Tranches receive principal in specified order
  2. All tranches with outstanding principal receive a coupon
  3. Shortest tranche gets all collateral principal until fully paid off
  4. Tranche coupons are lower than collateral coupon (e.g. a “5.0/5.5 sequential”)
  5. Discount bonds will yield more at higher PSA speeds
253
Q

Describe Planned Amortization Classes (PACs)

A
  • More stable than a sequential
  • Pays scheduled principal while prepayments are within a PSA band
  • Support bonds absorb prepayments above the low end of the band
  • After companion is retired, PAC is broken :(
  • PAC bands drift (generally tighten)
  • PAC 2s have tighter bands (serve as additional PAC support)
254
Q

List 5 evaluating decisions to buy a PAC

A
  1. Do I need cash flow stability?
  2. Is the cash flow stability cheap?
  3. Is it cheaper to hedge non-PACs with options?
  4. Is the bond market range-bound?
  5. What does current and implied volatility look like?
255
Q

Compare agency vs. non-agency CMOs:

  • Interest shortfall
A
  • Agencies guarantee all interest
  • Non-agency CMOs may be subject to interest shortfall
256
Q

Compare agency vs. non-agency CMOs:

  • Prepayment model
A
  • Agencies use a standard model
  • Non-agencies use specialized models based on collateral
257
Q

Compare agency vs. non-agency CMOs:

  • Collateral
A
  • Agency collateral is higher quality
  • Non-agencies use jumbo/nonconforming loans
258
Q

Compare agency vs. non-agency CMOs:

  • Delays
A
  • Similar to credit support
259
Q

Compare agency vs. non-agency CMOs:

  • Credit support
A
  • Agencies guarantee underlying mortgages
  • Non-agencies use credit enhancement techniques like subordination
260
Q

Describe 3 different types of CMO Analysis

A
  1. Cash flow analysis – test prepayment sensitivity, etc.
  2. OAS analysis – compare classes of similar duration
  3. Hedging – use key rate or partial duration analysis
261
Q

List at least 4 investor goals and constraints for CMOs

A
  1. Minimum yield requirements
  2. OAS requirements for relative-value investors
  3. Liquidity requirements
  4. Cost of raising money to purchase MBS
  5. Maturity or duration restrictions
  6. Dollar price limit
262
Q

List issues in OAS analysis

A
  1. Term structure models that are too simple or inconsistent
  2. Forward curve bias (but can exploit with derivatives)
  3. Prepayment model accuracy (account for age, relative coupon, impairments, and
  4. burnout)
  5. Securities created from collateral may be more valuable than collateral
  6. Deal call risk (e.g. cleanup calls)
263
Q

Describe the payoff of a FRA

A
  • A borrower enters an FRA to hedge against rising borrowing costs
  • The borrower’s payoff is positive if the actual borrowing rate > rFRA
  • The lender’s payoff is always the negative of the borrower’s
  • If paid at time of borrowing, the payment is “tailed” by the current rate rt
264
Q

Describe how Eurodollar futures can be used for hedging

A
  • To lock in a borrowing (lending) rate, short (buy) Eurodollar futures
  • The payoff is positive if LIBOR is higher than the locked-in forward rate
  • The lender’s payoff is always the negative of the borrower’s
265
Q

Compare and contrast the differences between Eurodollar Futures vs. FRAs

A

Key difference: Eurodollar futures systematically favor borrowers

Both can be used to lock in borrowing or lending rates

  • The Eurodollar futures payoff is always at time of borrowing
  • FRAs can payoff at time of borrowing or arrears
  • If paid at time of borrowing, FRAs are automatically tailed at current rate
  • Eurodollar futures can only be tailed at the forward rate (“convexity bias”):
266
Q

Compare LIBOR vs. 3-Month T-Bills

A

LIBOR > Treasury rates because of:

  1. Default premium in LIBOR rates
  2. Higher liquidity premium in LIBOR rates
  3. Market fluctuations that cause spreads to widen
  4. State tax exemption of Treasuries

LIBOR is far more common for futures contracts

  • Tracks private lending rates better than T-bills
267
Q

Define a treasury note futures contract

A

A Treasury note futures contract will specify:

  • Underlying bond’s YTM and maturity (e.g. 6% 10-year T-note)
  • Acceptable maturity range of delivered note: e.g. 6.5–10 years
  • Conversion factor: price of delivered note at underlying’s YTM (e.g. 6%)
268
Q

Define the invoice price and no-arbitrage price of a futures contract

A

Invoice Price = Futures Price at Maturity x Conversion Factor + Accrued Interest

The no-arbitrage futures price is:

Futures Price at Maturity = Price of CTD Bond/Conversion Factor of CTD Bond

269
Q

Describe how to find the CTD Bond

A
  1. Identify all available bonds falling within the maturity range (6.5–10 years)
  2. Calculate the price of each one at the underlying’s YTM (6%)
    • Conversion factor = PV bond CFs at 6% (expressed per dollar)
    • E.g. if the price at 6% is 105, the conversion factor is 1.05
  3. The CTD bond is the bond that results in:

Invoice Price - Futures Price at Maturity x Conversion Factor = 0

*There should only be one bond that satisfies the above; all others will be negative

270
Q

Compare the clean price vs. dirty price of a bond

A
  • Dirty price = true market price of bond (PV bond CFs at YTM)
  • Clean price = Dirty Price Accrued Interest
  • Accrued interest = prorated portion of the coupon since the last coupon date

Accrued Interest = Days Since Last Coupon/Total Days Between Coupon Dates

271
Q

Describe the basics of a swap

A

Swap = 2 counterparties agree to exchange periodic interest on a notional amount

  • Fixed payer: pays a fixed interest rate
  • Floating payer: pays a floating interest rate (LIBOR is commonly used)

At inception, PV(Fixed) = PV(Floating) ⇒ zero value at inception

272
Q

Describe the relationship between swaps and forwards

A

A swap can be created from a package of forwards

  • Fixed payer is long a forward on a floater
  • Floating payer is short a forward on a floater
273
Q

List 3 advantages of swaps over forwards

A
  1. Swap maturities can be much longer (15+ years)
  2. Swaps are more efficient (forwards have to be individually negotiated)
  3. Swaps are more liquid
274
Q

Define the following with respect to swaps:

  • Leg
A
  • refers to each side of a swap (floating leg, fixed leg)
275
Q

Define the following with respect to swaps:

  • Swap spread
A
  • spread over N-year Treasury (e.g. the 40 and 50 bps above)
276
Q

Define the following with respect to swaps:

  • N-year swap quoted as ”40-50”
A
  • An N-year swap quoted as “40-50” means that a dealer is willing to
  1. Pay a fixed rate equal to the N-yr Treasury Yield + 40 bps
  2. Receive a fixed rate equal to the N-yr Treasury Yield + 50 bps
277
Q

Define the following with respect to swaps:

  • LIBOR “flat”
A
  • when the floating payment is based on LIBOR without any spread
278
Q

Define the following with respect to swaps:

  • Reset or setting date
A
  • when floating interest payment is determined
  • Floating rate for each period is known at BOP and paid at EOP
279
Q

Define the following with respect to swaps:

  • Trade date
A

swap transaction date

280
Q

Define the floating and fixed payment formulas

A

Floating Paymentt = Notional x LIBORt x Dayst/360

Fixed Paymentt = Notional x SR x Dayst​/360

Payments are based on actual days per period (e.g. 89–92 days per quarter)

281
Q

Define a swaption

A

option to enter a swap at a future date

282
Q

Describe the following swaptions:

  • Receive-fixed swaption
A
  • gives option buyer the right to be the floating-payer
  • will exercise if prevailing swap rate
283
Q

Describe the following swaptions:

  • Pay-fixed swaption
A
  • gives option buyer the right to be the fixed-payer
  • will exercise if prevailing swap rate > strike rate
284
Q

List 4 factors that affect swaption values

A
  1. Changes in the Yield Curve
  2. Volatility (vega)
  3. Strike Rate
  4. Time to Expiration (depends)
285
Q

Describe 4 factors that affect swaption values

  • Strike Rate
A
  • Higher strikes lower the value of a pay-fixed swaption
  • Higher strikes increase the value of a receive-fixed swaption
286
Q

Describe 4 factors that affect swaption values

  • Volatility (vega)
A
  • All swaptions increase in value as interest rate volatility increases
287
Q

Describe 4 factors that affect swaption values

  • Changes in the Yield Curve
A
  • Pay-fixed options increase in value when interest rates rise or yield curve steepens
  • Receive-fixed options are the opposite
288
Q

Describe a credit default swap (CDS)

A

Protection buyer pays an ongoing premium to protection seller

  • Premium = coupon based on notional value of reference entity bond
  • “Premium leg” = PB’s side
  • “Protection leg” = PS’s side
289
Q

Describe 2 ways that a protection seller can settle if a credit event impairs the reference entity bond

A
  • Cash settlement: PS pays cash = Par - MV of Deliverable Obligations
  • Physical settlement: PS pays notional in cash to PB, who delivers bonds to PS
290
Q

List at least 5 uses of credit derivatives

A
  1. Transferring credit risk to an investor (most basic use)
  2. Hedge credit risk bond-by-bond or market-wide
  3. Greater customization (bilateral OTC market)
  4. Easy transaction with tight bid/ask spreads
  5. Leverage and yield enhancement (CDS upfront payment is small/zero)
  6. Pure credit play and risk decomposition
  7. Speculation on credit market
  8. Structured credit investments (CDS are building blocks for exotic structures)
  9. Hedge credits that have a high regulatory capital charge
291
Q

What is the upfront fee of a CDS at inception?

A
  • At inception, an upfront fee is calculated such that:

PV(Expected Premiums) + Upfront Fee = PV(Expected Credit Loss)

  • The premium leg is based on a fixed coupon rate
292
Q

Define the value that the protection seller must pay the protection buyer if a credit event triggers the CDS

A

If a credit event triggers the CDS, the PS must pay the PB

Par - MV of Deliverable Obligations

293
Q

List the 2 types of credit events affecting CDS

A
  1. Hard credit events
  2. Soft credit events
294
Q

Describe the 2 types of credit events affecting CDS:

  • Soft credit events
A
  • Results in a basket of deliverables that are priced differently
  • Increases the value of the PB’s delivery option (hurts PS)
  • PB may prefer not to trigger the CDS if a hard event could occur later
295
Q

Describe the 2 types of credit events affecting CDS:

  • Hard credit events
A
  • Debts are pari passu (equal claim on recoveries)
  • Includes bankruptcy and failure to pay on debt
  • Included in North America, Europe, and Asia
296
Q

List and describe 4 clauses that limit value of the delivery option

A
  1. Old-Restructuring (“Old-Re”) – pre-2003 standard that imposes a 30-year maturity limit on deliverables
  2. Modified-Restructuring (“Mod-Re”) imposes complicated maturity limits on deliverables
  3. Modified-Modified Restructuring (“Mod-Mod Re”) – European standard similar to Mod-Re
  4. No-Restructuring (“No-Re”) – restructuring is not an allowed credit event
297
Q

List 3 main objectives of the CDS auction process

A
  1. Handle cases where notional >= total outstanding notional of deliverable obligations
  2. Ensure uniform recovery price across entire CDS market
  3. Handle restructuring clauses (e.g. Mod-Re)
298
Q

Describe the 6 steps in the CDS settlement timeline

A
  1. Suspected credit event occurs
  2. Send request to DC to consider event
  3. Compression cycle – reduces number of contracts that need to be settled
    • Allow groups of counterparties to cancel out mutually offsetting positions
  4. If hard credit event, proceed to auction; else for restructuring events only:
    • Publish maturity buckets
    • Triggering of CDS contracts
    • Deadline of movement option
  5. Auction is held
  6. Auction settlement
299
Q

Describe characteristics of high yield bonds

A

High yield bonds (“junk bonds”) are below investment grade (below BBB- or Baa3)

  • Common issuers: fallen angels, start-ups, LBOs, etc.
  • Typical investors are seeking higher yield (mutual funds, pensions, insurers)
  • CDOs repackage high yield bonds in pools
  • Coupons can be fixed, floating, or PIK
  • Maturity is usually 7–10 years
300
Q

Describe unique aspects of SEC registration related to high yield bonds

A

Rule 144A – allows most high yield bonds to not be registered with the SEC initially

  • Allows QIBs to buy/sell without SEC registration
  • Drawback: bonds issued under 144A are less liquid

Well-known, seasoned issuers (WKSIs) get preferential treatment

  • File reports in a timely manner
  • Over $700 million in market capitalization
  • Issued $1 billion in registered debt offerings over the past 3 years
301
Q

List the 3 steps in a typical underwriting process for a high yield bond

A
  1. Prepare the prospectus
  2. Negotiate terms with investors
  3. Syndication and allocation
302
Q

List 5 key items included in a high yield bond offering

A
  1. Offering memorandum (exec summary, investment considerations, etc.)
  2. Prospectus (issuer description, key financials, etc.)
  3. Preliminary term sheet (pricing, structure, collateral, etc.)
  4. Commitments by the underwriters
  5. Industry overview and competitive position
303
Q

List 3 types of syndication

A
  1. Underwritten (most common)
  2. Bought deal
  3. Back-stop deal
304
Q

Describe 3 types of syndication:

  • Back-stop deal
A
  • Similar to a bought-deal, but longer timeframe (up to one week)
305
Q

Describe 3 types of syndication:

  • Bought deal
A

Bought deal: fully guaranteed/purchased by underwriter at an undisclosed rate

  • Shifts execution and market risk from issuer to underwriter
  • Allows underwriter to outbid other underwriters
  • More likely with well-known, seasoned issuers
  • Timing is typically <= 1 day, which lessens market risk
306
Q

Describe 3 types of syndication:

  • Underwritten (most common)
A
  • marketed on a “best efforts” basis
  • Underwriter has no obligation to complete the transaction
307
Q

Describe NAREIT

A
  • market-cap weighted index of REITs
  • Includes leveraged investment (debt capital)
  • Hedged NAREIT = NAREIT with S&P 500 stock correlation removed

*both NCREIF and NAREIT have major issues that should be understood when using as benchmarks

308
Q

Describe NCREIF

A
  • popular benchmark for direct RE investment
  • Value-weighted sample of commercial properties owned by large US firms
  • Non-leveraged investment only
  • Values are based on infrequent property appraisals
  • Unsmoothed NCREIF – corrected for “stale” valuations
  • Not investable

*both NCREIF and NAREIT have major issues that should be understood when using as benchmarks

309
Q

List the at least 5 characteristics that affect real estate returns

A
  1. Lack of liquidity
  2. Large lot sizes
  3. High transaction costs
  4. Heterogeneity
  5. Immobility
  6. Low information transparency
  7. Not exchange traded
310
Q

Describe the market and economic factors that affect real estate

A
  1. Interest rates – business financing, employment, savings habits, mortgage rates
  2. Gross national product – positively correlated with RE returns
  3. Population growth – positively correlated with RE returns
  4. Inflation – RE may hedge but research is mixed
  5. Location is very important
  6. International investing can provide diversification
311
Q

Describe the advantages of direct real estate investing

A
  1. Tax subsidies – deductible mortgage interest, property taxes
  2. Leverage – mortgages allow more leverage with RE than other securities
  3. More direct control over property compared to stocks
  4. Geographic diversification – low correlations across different regions
  5. Relatively low volatility compared to stocks
312
Q

Describe the disadvantages of direct real estate investing

A
  1. Can result in large concentrations
  2. High information cost due to uniqueness of each property
  3. High commissions paid to brokers
  4. High operating and maintenance costs
  5. Risk of neighborhood deterioration
  6. Political risk – tax deductions could go away
313
Q

Why is real estate used as a stock/bond diversifier?

  • Observations when adding RE to a stock/bond portfolio
A
  • Adding direct or indirect RE investment can increase the Sharpe ratio
  • Adding RE is redundant if portfolio also contains commodities and hedge funds
  • Direct RE offers more diversification benefits than REITs
314
Q

Why is real estate used as a stock/bond diversifier?

  • Compared to stocks and bonds
A
  • RE has low correlation
  • RE has lower volatility than stocks
  • Commercial rental income is often stable
315
Q

Describe how diversification is applied within real estate

A
  • Diversify by type and geography
  • Apartments have higher returns and less volatility compared to large offices
    • Apartment returns are negatively correlated with inflation
  • Direct RE has high persistence in returns (+ follows +, - follows -)
  • Not true for indirect RE
    • International RE adds additional diversification
316
Q

Compare and contrast tactical and strategic asset allocation with respect to real estate

  • Other SAA Considerations
A
  • Direct RE may provide an inflation hedge
  • RE improves Sharpe ratio
  • Unsmoothed NCREIF returns should be used
  • REITs offer higher liquidity
317
Q

Compare and contrast tactical and strategic asset allocation with respect to real estate

  • SAA
A

systematic factors affecting RE returns

  • Growth in consumption
  • Real interest rates
  • Term structure of interest rates
  • Unexpected inflation
318
Q

Compare and contrast tactical and strategic asset allocation with respect to real estate

  • TAA
A

RE tends to follow economic cycles (requires good forecasting)

319
Q

Describe why LIBOR is being replaced and why it is a big deal

A

LIBOR is going away in 2021 because it is no longer trusted

  • 2012 investigation revealed that banks falsified quotes to increase profits
  • Banks are not required to actually transact at their quoted prices
  • May publish false rates to manipulate LIBOR (increase their own profits)
320
Q

What is the problem with getting rid of LIBOR

A

Problem: LIBOR affects $200 trillion of US derivatives and other variable rate contracts

  • Will require adjustments ⇒ creates uncertainty around future contract values
321
Q

How are regulators around the world replacing LIBOR?

A
  • US will use the Secured Overnight Financing Rate (SOFR)
  • Other countries/regions: SONIA (UK), EONIA (EU), and TONAR (Japan)
322
Q

Compare the US Securities Overnight Financing Rate to LIBOR

  • Currency basis
A
  • SOFR: USD only
  • LIBOR: 5 different currencies
323
Q

Compare the US Securities Overnight Financing Rate to LIBOR

  • Term structure
A
  • SOFR: 1 day (overnight lending rate)
  • LIBOR: 7 different maturities
324
Q

Compare the US Securities Overnight Financing Rate to LIBOR

  • Credit risk
A
  • SOFR: virtually risk-free since based on Treasury bonds
  • LIBOR: reflects credit risk of banks
325
Q

Compare the US Securities Overnight Financing Rate to LIBOR

  • Basis for rate
A
  • SOFR: Treasury overnight repo rate (extremely high volume and trustworthy)
  • LIBOR: 35 bank quotes that aren’t based on observable transactions

ILA Track (5 decks)

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