ILA-LPM E

Question 1

Describe 2 situations where disintermediation can occur

Answer 1

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

Question 2

Describe how disintermediation has impacted the life insurance industry

Answer 2

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)

Question 3

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

Answer 3

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

Question 4

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

• Cash flow volatility

Answer 4

• Risk of delays in reinvesting cash flows from investments

Question 5

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

• Credit risk in the asset portfolio

Answer 5

• Solutions: AVR, portfolio diversification
• Accounting challenges: FAS 115

Question 6

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

• Reinvestment risk from falling interest rates

Answer 6

• Must fund minimum guaranteed crediting rates

Question 7

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

• Valuation concerns from rising interest rates (risk of surplus loss)

Answer 7

• Disintermediation: when interest rates rise, liabilities increase and asset MVs decreases
• Solutions: RBC, ALM

Question 8

What is the key return objective for life insurers?

Answer 8

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

Question 9

Describe the importance of liquidity for life insurers

Answer 9

• 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

Question 10

Describe how the following affect life insurance asset portfolio management

• Taxes

Answer 10

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

Question 11

Describe how the following affect life insurance asset portfolio management

• Insurance is heavily regulated

Answer 11

• (mostly at state level)
• Restrictions on eligible investments
• Prudent investor rule (instead of “laundry list”)
• Valuation method (NAIC’s Security Valuation Book)

Question 12

Describe how the following affect life insurance asset portfolio management

• Time horizon

Answer 12

• varies by LOB (longer for life products, shorter for annuities)

Question 13

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

Answer 13

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.)

Question 14

Describe tactical asset allocation (TAA)

Answer 14

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

Question 15

Describe strategic asset allocation (SAA)

Answer 15

• 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”

Question 16

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

• Terminal wealth impact: asset allocation vs. security selection

Answer 16

• Security selection results in greater dispersion of terminal wealth
• Conclusion: security selection can add value but also risk

Question 17

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

• regression analysis

Answer 17

• 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)

Question 18

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

• what is the key takeaway?

Answer 18

• asset allocation explains nearly all of long-term portfolio returns

Question 19

List the key conclusions on SAA based on empirical studies

Answer 19

• 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

Question 20

Compare and contrast asset–only vs asset and liability management

Answer 20

• 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

Question 21

List the key investor-related considerations for choosing ALM

Answer 21

• 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

Question 22

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

Answer 22

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

Question 23

Describe some quantitative return objectives with respective to SAA

Answer 23

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

Question 24

Describe some quantitative return objectives with respective to SAA

• Arithmetic (additive) vs. multiplicative (geometric)

Answer 24

• 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

Question 25

List some quantitative methods for evaluating risk tolerance

Answer 25

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

Question 26

Describe some quantitative methods for evaluating risk tolerance:

• Minimize probability of not meeting threshold return

Answer 26

• (same result as minimizing shortfall risk)
• Minimize explicit probability: Pr[R_P < R_L] = Ø(-SFRatio)

Question 27

Describe some quantitative methods for evaluating risk tolerance:

• Minimize shortfall risk

Answer 27

• risk of falling below a threshold return
• Maximize Roy’s safety-first ratio or the Sharpe ratio

Question 28

Describe some quantitative methods for evaluating risk tolerance:

• Mean-variance approach

Answer 28

• maximize risk-adjusted expected return (utility)
• Risk-adjusted return U_m falls as investor risk aversion and/or σ increases
• Pick the portfolio m with the highest U_m

Question 29

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

Answer 29

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

U_m = E(R_m) - 0.005R_Aσ²_m

E(R_m) = expected return of asset mix

0.005R_Aσ²_m = “risk penalty”

R_A = value of risk aversion

σ_m = standard deviation of asset mix

Where R_A comes from a questionnaire:

• R_A of 6–8: high risk aversion (low risk tolerance)
• R_A of 1–2: low risk aversion (high risk tolerance)

Question 30

Define shortfall risk

Answer 30

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

Question 31

Describe the “safety-first optimal portfolio”

Answer 31

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

SFRatio = (E(R_P) - R_L)/σ_P

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

Question 32

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

Answer 32

Sharpe ratio = SFRatio using the risk-free rate R_F for R_L

SharpeRatio = [E(R_P) - R_F]/σ_P

Question 33

Describe the standard normal probability approach for quantifying shortfall risk

Answer 33

Standard normal probability approach: choose portfolio with the lowest:

Pr[R_p < R_L] = Ø(-SFRatio)

Question 34

List 3 the behaviorial influences on asset allocation

Answer 34

1. Loss aversion
2. Mental accounting
3. Regret avoidance

Question 35

Describe the behaviorial influences on asset allocation:

• Mental accounting

Answer 35

• 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

Question 36

Describe the behaviorial influences on asset allocation:

• Regret avoidance

Answer 36

• fear of regret
• May promote diversification
• May limit divergence from peers
• May make investors want to establish risky positions slowly

Question 37

Describe the behaviorial influences on asset allocation:

• Loss aversion

Answer 37

• 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

Question 38

List the criteria for specifying asset classes

Answer 38

• 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

Question 39

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

Answer 39

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

SharpeRatio_N > SharpeRatio_P x Corr(R_N,R_P)

Question 40

List and describe special issues for international asset classes

Answer 40

• 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)

Question 41

List some examples of alternative investments

Answer 41

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

Question 42

What are some concerns when investing in alternative investments?

Answer 42

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

Question 43

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

Answer 43

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

Question 44

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

Answer 44

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!)

Question 45

Describe the strategies for managing against a bond market index:

• Enhanced indexing by matching primary risk factors

Answer 45

• Primary risk factors: interest rate level, yield curve twists, and spreads
• Cheaper than pure indexing and allows opportunity for higher yield

Question 46

Describe the strategies for managing against a bond market index:

• Enhanced indexing by small risk factor mismatches

Answer 46

• Match duration, while actively managing smaller risk factors (sector, quality, etc.)

Question 47

Describe the strategies for managing against a bond market index:

• Pure bond indexing

Answer 47

• (or full replication)
• Attempts perfect match (own all bonds in index)
• Rare: expensive and inefficient

Question 48

List the 3 reasons for using indexing

Answer 48

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

Question 49

Describe the risk factors to consider when choosing an index

Answer 49

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

Question 50

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

Answer 50

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)

Question 51

List the primary bond risk factors

Answer 51

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)

Question 52

What is the tracking risk?

Answer 52

standard deviation of the portfolio’s active return over time

Question 53

Describe the main disadvantage of using enhanced bond management strategies

Answer 53

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

Question 54

Describe strategies to overcome the high costs of enhanced indexing

Answer 54

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

Question 55

Describe some additional activities that are carried out by active managers

Answer 55

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

Question 56

Define total return with respect to bond returns

Answer 56

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

Question 57

Describe the benefits of scenario analysis

Answer 57

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

Question 58

List the 2 types of dedication strategies

Answer 58

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

Question 59

4 extensions for immunization

Answer 59

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

Question 60

Describe cash flow matching

Answer 60

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

Question 61

List the 2 requirements for classical single period immunization

Answer 61

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

Question 62

List the important characteristics of immunization

Answer 62

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

Question 63

Describe 2 ways that a portfolio’s duration can change

Answer 63

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

Question 64

Define the immunized target rate of return

Answer 64

• 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

Question 65

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

Answer 65

• 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

Question 66

Define spread duration

Answer 66

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

Question 67

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

Answer 67

• 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

Question 68

Describe the steps under multiple liability immunization

Answer 68

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

Question 69

Describe the steps for immunizing general cash flows

Answer 69

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

Question 70

What is the goal of return maximization for immunized portfolios?

Answer 70

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

Expected Return +/- 2σ

Question 71

Describe contingent immunization

Answer 71

• 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

Question 72

Describe the sources of liability funding risk

Answer 72

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

Question 73

Describe the importance of reinvestment risk

Answer 73

Portfolios with the least reinvestment risk have the least immunization risk

Question 74

Describe the differences between cash flow matching and multiple liability immunization

Answer 74

• 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!

Question 75

List the 2 extensions of basic cash flow matching

Answer 75

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

Question 76

Describe the 2 extensions of basic cash flow matching

• Symmetric cash flow matching

Answer 76

• Borrow short-term money to meet liability
• Invest in longer assets that will mature after the liability

Question 77

Describe the 2 extensions of basic cash flow matching

• combination matching (a.k.a. horizon matching)

Answer 77

• 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

Question 78

List the considerations when applying dedication strategies

Answer 78

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

Question 79

Describe 2 combination dedication strategies

Answer 79

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

Question 80

Define a repo agreement

Answer 80

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

Question 81

What are the characteristics of a repo agreement?

• Repos offers a low cost way to borrow short-term funds

Answer 81

• 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

Question 82

What are the characteristics of a repo agreement?

• Methods of transferring securities between parties

Answer 82

• 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)

Question 83

What are the factors that increase the repo rate?

Answer 83

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

Question 84

List the 4 non-duration risk measures

Answer 84

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

Question 85

Describe the non-duration risk measures and their disadvantages:

• Semivariance

Answer 85

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

Question 86

Describe the non-duration risk measures and their disadvantages:

• Shortfall risk

Answer 86

• Does not account for the magnitude of losses

Question 87

Describe the non-duration risk measures and their disadvantages:

• Value at risk (VaR)

Answer 87

• estimates the loss at a given percentile
• does not capture magnitude of losses beyond the specified percentile

Question 88

Describe the non-duration risk measures and their disadvantages:

• Standard deviation (or variance)

Answer 88

• 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

Question 89

List the products used in derivatives-enabled strategies

Answer 89

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)

Question 90

Define interest rate futures and forwards

Answer 90

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

Question 91

Define basis risk

Answer 91

Basis = Bond Cash Price - Futures Price

• Basis risk = risk of unpredictable changes in the basis

Question 92

Define cross hedging

Answer 92

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

Question 93

List the 3 major sources of hedging error

Answer 93

1. Incorrect duration
2. Projected basis
3. Yield beta

Question 94

Define an interest rate swap

Answer 94

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

Interest Payment = Specified Interest Rate x Notional Amount

Question 95

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

Answer 95

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

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

Question 96

List the 3 ALM applications of swaps

Answer 96

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

Question 97

Define option duration

Answer 97

Option Duration = Duration of Underlying

x Option Delta

x (Price of Underlying/Price of Option Instrument)

Question 98

List 3 ways that hedging can be done with options

Answer 98

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

Question 99

Describe credit spread options

Answer 99

• 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

Question 100

Describe credit forwards

Answer 100

• 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”

Question 101

Describe credit default swaps (CDS)

Answer 101

• 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

Question 102

List the advantages and uses of CDS

Answer 102

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

Question 103

Define internal cash flows and external cash flows

Answer 103

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

Question 104

Define the total rate of return

Answer 104

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

Question 105

Describe the time-weighted rate of return (TWR)

Answer 105

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

*Must be calculated every time an external cash flow occurs

Question 106

Describe the money-weighted rate of return (MWR)

Answer 106

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

Question 107

Describe the linked internal rate of return (LIRR)

Answer 107

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)

Question 108

Describe the relationship between linked IRR and time-weighted return

Answer 108

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

Question 109

List 2 data quality issues when calculating rate of returns

Answer 109

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

Question 110

Describe some data quality issues when calculating rate of returns

• Reported rates of return are only as accurate as their inputs

Answer 110

• 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

Question 111

Describe some data quality issues when calculating rate of returns

• ​Reliable performance measures also require appropriate data collection procedures

Answer 111

• Report on a trade-date, fully accrued basis
• Reflect impact of unsettled trades and income owed but not paid

Question 112

Define the conventional yield measure current yield

Answer 112

Current yield – only measures coupon income

Current Yield = Annual Dollar Coupon Interest/Price

Question 113

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

Answer 113

• 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

Question 114

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

Answer 114

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

Question 115

Define total return

Answer 115

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

Question 116

Describe the significance of interest-on-interest

Answer 116

• 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

Question 117

Describe Yield-to-Call

Answer 117

• 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

Question 118

Describe yield-to-worst

Answer 118

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

Question 119

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

Answer 119

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

Question 120

Describe problems that are specific to YTC

Answer 120

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

Question 121

Describe a floating-rate bond

Answer 121

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

Coupon_t = (R_t + Spread) x Par

Therefore, the coupon values are unknown

Question 122

Define discount margin with respect to a floating-rate bond

Answer 122

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

Question 123

Describe the steps to determine the discount margin

Answer 123

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

Question 124

Describe how to evaluate potential bond swaps

Answer 124

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

Question 125

Define taxable equivalent yield

Answer 125

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)

Question 126

List 2 problems with taxable equivalent yield and a possible solution

Answer 126

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

Question 127

Define liquidity risk

Answer 127

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

Question 128

Define the liquidity coverage ratio

Answer 128

Liquidity Coverage Ratio = Cash Sources/Cash Needs

(should be >= 100%)

Question 129

List 5 cash sources

Answer 129

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

Question 130

List 3 cash needs

Answer 130

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

Question 131

List the 7 principles of liquidity risk management

Answer 131

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

Question 132

Describe the contents of a liquidity policy

Answer 132

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

Question 133

Describe the purpose and use of a liquidity stress management plan

Answer 133

• 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

Question 134

List types of liquidity stress tests

Answer 134

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

Question 135

Describe types of liquidity stress tests and their respective considerations

• Customer panic scenario

Answer 135

• Impact of falling equity markets, rising credit spreads, and/or cat losses
• Assume full withdrawals fixed deferred annuities

Question 136

Describe types of liquidity stress tests and their respective considerations

• Impaired markets/panic withdrawal scenario

Answer 136

• “run on the book”
• Very difficult to manage if capital market liquidity has vanished
• Requires access to other external cash sources

Question 137

Describe types of liquidity stress tests and their respective considerations

• Impaired markets scenario

Answer 137

• capital markets become frozen for 3–6 months
• Impossible to sell assets during this time

Question 138

Describe types of liquidity stress tests and their respective considerations

• Catastrophic claims scenario

Answer 138

• simulate a catastrophic event
• Consider interdependency between capital markets and catastrophes
• Mitigate with diverse products and reinsurance cash loss clauses

Question 139

Describe types of liquidity stress tests and their respective considerations

• Disintermediation scenario

Answer 139

• 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

Question 140

Describe liquidity risk in policyholder funds

Answer 140

• 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

Question 141

Who is the investment actuary

Answer 141

liaison between product actuaries and portfolio managers

Question 142

Describe how an investment actuary adds value

Answer 142

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

Question 143

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

Answer 143

• 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

Question 144

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

Answer 144

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

Question 145

Describe the long-term investment process, under specific guidelines

Answer 145

• 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

Question 146

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

Answer 146

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)

Question 147

Compare the realities of trading stocks vs. bonds

Answer 147

• 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”

Question 148

List 4 constraints on asset sales

Answer 148

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

Question 149

Describe constraints on asset sales:

• Credited rates and policyholder equity

Answer 149

• Selling a high-yielding bond can hurt crediting rates
• Constraints on credit quality, maturity structure, or concentration

Question 150

Describe constraints on asset sales:

• Asset/Liability Management

Answer 150

• Bond prices usually increase before upgrades
• Riding the yield curve — unrealized gains emerge as bond approaches maturity

Question 151

Describe constraints on asset sales:

• Embedded value / economic value added

Answer 151

• Impact is usually minimal

Question 152

Describe constraints on asset sales:

• Accounting

Answer 152

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

Question 153

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

Answer 153

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

Question 154

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

Answer 154

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

Question 155

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

Answer 155

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

Question 156

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

Answer 156

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

Question 157

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

Answer 157

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

*Treasury notes account for the vast majority outstanding

Question 158

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

• Treasury Inflation-Protected Securities (TIPS)

Answer 158

• Principal is inflation-adjusted by CPI
• Coupons = fixed % of inflation-adjusted principal

Question 159

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

• Coupon securities

Answer 159

• “Notes” have 2–10 year maturities
• “Bonds” have maturities > 10 years

Question 160

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

• Discount securities

Answer 160

• (no coupons)
• T-bills have a maturity <= 1 year

Question 161

Describe the primary market auction process

Answer 161

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

Question 162

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

Answer 162

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)

Question 163

Describe how “Zeros” and “Strips” are created

Answer 163

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

Question 164

Describe the credit quality of agency securities

Answer 164

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

Question 165

Why are agencies attractive to investors?

Answer 165

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)

Question 166

List the 3 different types of agency securities

Answer 166

1. Short-dated
2. Longer-dated
3. Callable agencies

Question 167

Describe the 3 different types of agency securities:

• Longer-dated

Answer 167

• (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

Question 168

Describe the 3 different types of agency securities:

• Callable agencies

Answer 168

• (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

Question 169

Describe the 3 different types of agency securities:

• Short-dated

Answer 169

• (1–365 days)
• “discount notes” priced like T-bills

Question 170

Describe the primary agency market

Answer 170

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

Question 171

Describe the secondary agency market

Answer 171

The Secondary Market

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

Question 172

Describe 3 properties of municipal bonds

Answer 172

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

Question 173

Describe 4 features of municipal bonds

Answer 173

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

Question 174

List reasons why credit risk for municipal bonds has been increasing

Answer 174

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

Question 175

List 5 types of municipal bonds

Answer 175

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

Question 176

Describe types of municipal bonds:

• Municipal derivatives

Answer 176

• instruments created from municipals
• Floaters, inverse floaters, tender option bonds

Question 177

Describe types of municipal bonds:

• Money market products

Answer 177

• Notes (12-mo), commercial paper, VRDOs, commercial paper mode

Question 178

Describe types of municipal bonds:

• Hybrid and special bond securities

Answer 178

• Least risky: refunded bonds have security held in escrow
• Others: dedicated tax-backed, lease-backed, LOC-backed, etc.

Question 179

Describe types of municipal bonds:

• Hybrid and special bond securities

Answer 179

• Least risky: refunded bonds have security held in escrow
• Others: dedicated tax-backed, lease-backed, LOC-backed, etc.

Question 180

Describe types of municipal bonds:

• Revenue bonds

Answer 180

• backed by revenue from specific projects

Question 181

Describe types of municipal bonds:

• General obligation bonds

Answer 181

• secured by taxing powers
• Full faith and credit obligations vs. limited-tax GOBs

Question 182

What are the factors affecting valuation of a municipal bond?

Answer 182

• maturity
• offered price
• call features
• sinking funds
• credit quality

Question 183

Describe valuation methods for municipal bonds

Answer 183

• 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

Question 184

Formula for an equivalent taxable yield for a municipal bond

Answer 184

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

Question 185

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

Answer 185

• 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

Question 186

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

Answer 186

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

Question 187

Describe the fundamentals of a corporate bond

Answer 187

• 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)

Question 188

Describe the following coupon types:

• Deferred-interest bond (DIB)

Answer 188

• 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

Question 189

Describe the following coupon types:

• Pay-in-kind (PIK) debentures

Answer 189

• Pays additional pieces of security instead of coupons
• Additional securities can be sold separately
• higher credit risk than straight coupon bonds

Question 190

Describe the following coupon types:

• Zero

Answer 190

• 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

Question 191

List 5 different types of securities for bonds

Answer 191

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

Question 192

Describe the different types of securities for bonds:

• Guaranteed Bonds

Answer 192

• guaranteed by one or more other companies

Question 193

Describe the different types of securities for bonds:

• Equipment Trust Certificates

Answer 193

• 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

Question 194

Describe the different types of securities for bonds:

• Collateral Trust Bonds

Answer 194

• backed by stock of issuer’s subsidiaries
• B/H protection: if issuer defaults, it forfeits voting rates on subsidiary stock

Question 195

Describe the different types of securities for bonds:

• Mortgage Bonds

Answer 195

• 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

Question 196

Describe the different types of securities for bonds:

• Debentures

Answer 196

• 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

Question 197

List 5 methods to retire debt before maturity

Answer 197

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

Question 198

Describe corporate bond call provisions

Answer 198

• 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

Question 199

Describe sinking fund provisions

Answer 199

• 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

Question 200

Define issuer default rate

Answer 200

Issuer default rate – based on number of defaulting issuers

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

Question 201

Define dollar default rate

Answer 201

based on amount of defaulted par

Question 202

Express dollar default rate as an annual default rate

Answer 202

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

Question 203

Express dollar default rate over a certain # of years

Answer 203

=Cumulative $ Value of All Defaulted Bonds/

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

Question 204

Define default loss rate and recovery rates

Answer 204

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

Question 205

Define event risk

Answer 205

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

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

Question 206

Define headline risk

Answer 206

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

Question 207

Give 3 unique features of high-yield bonds

Answer 207

• 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

Question 208

Describe unique features of high-yield bonds

• Deferred Coupon Structures (3 kinds)

Answer 208

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

Question 209

Describe unique features of high-yield bonds

• Extendible Reset Bonds

Answer 209

• 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

Question 210

Describe unique features of high-yield bonds

• clawback (high-yield bond)

Answer 210

• redemption of bonds during a non-callable period with IPO proceeds
• Can hurt bondholders since their investment would be rising

Question 211

List 5 properties of commercial paper

Answer 211

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

Question 212

Describe repurchase agreements (“repos”)

Answer 212

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

Question 213

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

Answer 213

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

Question 214

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

Answer 214

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

Question 215

List 3 ways of delivering repo collateral

Answer 215

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

Question 216

Define the repo rate

Answer 216

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

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

Question 217

What are the 4 determinants of the repo rate

Answer 217

• 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

Question 218

Describe 4 properties of the Federal funds market

Answer 218

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

Question 219

Describe the components of a pure floater’s coupon

Answer 219

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

Question 220

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

Answer 220

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

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

Question 221

Define an inverse floater

Answer 221

Inverse floater coupons move inversely with the reference rate K

= K - L x (Reference Rate)

Question 222

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

Answer 222

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

Question 223

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

Answer 223

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

Question 224

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

Answer 224

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 = (MV_FD_F + MV_IFDIF)/Fixed Bond MV

Question 225

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

Answer 225

• 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

Question 226

List 4 spread measures for evaluating floaters

Answer 226

1. Simple Margin
2. Adjusted Simple Margin
3. Adjusted Total Margin
4. Discount Margin

Question 227

Describe spread measures for evaluating floaters:

• Discount Margin

Answer 227

• Calculates the average expected spread over the life of the floater

Question 228

Describe spread measures for evaluating floaters:

• Adjusted Total Margin

Answer 228

• No. 2 plus interest earned by investing difference in floater’s par and the carry-adjusted price

Question 229

Describe spread measures for evaluating floaters:

• Adjusted Simple Margin

Answer 229

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

Question 230

Describe spread measures for evaluating floaters:

• Simple Margin

Answer 230

• a.k.a. Spread for Life
• Accounts for amortization of discount/premium in addition to quoted margin

Question 231

List 3 price volatility characteristics of floaters

Answer 231

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

Question 232

Describe 4 portfolio strategies using floaters

Answer 232

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

Question 233

Describe the payment characteristics of a mortgage

Answer 233

• 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

Question 234

Describe the loan underwriting process (mortgages)

Answer 234

• 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

Question 235

Back debt-to-income ratio

Answer 235

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

Question 236

Front debt-to-income ratio

Answer 236

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

Question 237

Describe the relationship between interest rates, prepayment, and duration

Answer 237

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

Question 238

List 5 items that impact mortgage prepayment risk

Answer 238

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

Question 239

Define the following measures of prepayment speeds

• PSA Model

Answer 239

• 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

Question 240

Define the following measures of prepayment speeds

• Conditional Prepayment Rate (CPR)

Answer 240

= annualized SMM

=1 - (1 - SMM)¹²

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

Question 241

Define the following measures of prepayment speeds

• Single Monthly Mortality (SMM)

Answer 241

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

Question 242

List 5 characteristics used to evaluate mortgage credit risk

Answer 242

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

Question 243

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

Answer 243

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

Question 244

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

Answer 244

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

Question 245

List 6 trading characteristics of MBS

Answer 245

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

Question 246

List 4 non-refinancing sources of prepayments

Answer 246

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

Question 247

List 4 non-interest rate driven refinancing sources of prepayments

Answer 247

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

Question 248

List 4 interest rate driven refinancing sources of prepayments

Answer 248

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

Question 249

Describe 4 MBS spread measures

Answer 249

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

Question 250

Briefly describe the CMO market

Answer 250

• 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

Question 251

List 4 primary “flavors” of sequentials and PACs

Answer 251

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)

Question 252

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

Answer 252

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

Question 253

Describe Planned Amortization Classes (PACs)

Answer 253

• 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)

Question 254

List 5 evaluating decisions to buy a PAC

Answer 254

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?

Question 255

Compare agency vs. non-agency CMOs:

• Interest shortfall

Answer 255

• Agencies guarantee all interest
• Non-agency CMOs may be subject to interest shortfall

Question 256

Compare agency vs. non-agency CMOs:

• Prepayment model

Answer 256

• Agencies use a standard model
• Non-agencies use specialized models based on collateral

Question 257

Compare agency vs. non-agency CMOs:

• Collateral

Answer 257

• Agency collateral is higher quality
• Non-agencies use jumbo/nonconforming loans

Question 258

Compare agency vs. non-agency CMOs:

• Delays

Answer 258

• Similar to credit support

Question 259

Compare agency vs. non-agency CMOs:

• Credit support

Answer 259

• Agencies guarantee underlying mortgages
• Non-agencies use credit enhancement techniques like subordination

Question 260

Describe 3 different types of CMO Analysis

Answer 260

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

Question 261

List at least 4 investor goals and constraints for CMOs

Answer 261

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

Question 262

List issues in OAS analysis

Answer 262

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)

Question 263

Describe the payoff of a FRA

Answer 263

• A borrower enters an FRA to hedge against rising borrowing costs
• The borrower’s payoff is positive if the actual borrowing rate > r_FRA
• 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 r_t

Question 264

Describe how Eurodollar futures can be used for hedging

Answer 264

• 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

Question 265

Compare and contrast the differences between Eurodollar Futures vs. FRAs

Answer 265

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”):

Question 266

Compare LIBOR vs. 3-Month T-Bills

Answer 266

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

Question 267

Define a treasury note futures contract

Answer 267

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%)

Question 268

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

Answer 268

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

Question 269

Describe how to find the CTD Bond

Answer 269

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

Question 270

Compare the clean price vs. dirty price of a bond

Answer 270

• 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

Question 271

Describe the basics of a swap

Answer 271

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

Question 272

Describe the relationship between swaps and forwards

Answer 272

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

Question 273

List 3 advantages of swaps over forwards

Answer 273

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

Question 274

Define the following with respect to swaps:

• Leg

Answer 274

• refers to each side of a swap (floating leg, fixed leg)

Question 275

Define the following with respect to swaps:

• Swap spread

Answer 275

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

Question 276

Define the following with respect to swaps:

• N-year swap quoted as ”40-50”

Answer 276

• 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

Question 277

Define the following with respect to swaps:

• LIBOR “flat”

Answer 277

• when the floating payment is based on LIBOR without any spread

Question 278

Define the following with respect to swaps:

• Reset or setting date

Answer 278

• when floating interest payment is determined
• Floating rate for each period is known at BOP and paid at EOP

Question 279

Define the following with respect to swaps:

• Trade date

Answer 279

swap transaction date

Question 280

Define the floating and fixed payment formulas

Answer 280

Floating Payment_t = Notional x LIBOR_t x Days_t/360

Fixed Payment_t = Notional x SR x Days_t​/360

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

Question 281

Define a swaption

Answer 281

option to enter a swap at a future date

Question 282

Describe the following swaptions:

• Receive-fixed swaption

Answer 282

• gives option buyer the right to be the floating-payer
• will exercise if prevailing swap rate

Question 283

Describe the following swaptions:

• Pay-fixed swaption

Answer 283

• gives option buyer the right to be the fixed-payer
• will exercise if prevailing swap rate > strike rate

Question 284

List 4 factors that affect swaption values

Answer 284

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

Question 285

Describe 4 factors that affect swaption values

• Strike Rate

Answer 285

• Higher strikes lower the value of a pay-fixed swaption
• Higher strikes increase the value of a receive-fixed swaption

Question 286

Describe 4 factors that affect swaption values

• Volatility (vega)

Answer 286

• All swaptions increase in value as interest rate volatility increases

Question 287

Describe 4 factors that affect swaption values

• Changes in the Yield Curve

Answer 287

• Pay-fixed options increase in value when interest rates rise or yield curve steepens
• Receive-fixed options are the opposite

Question 288

Describe a credit default swap (CDS)

Answer 288

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

Question 289

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

Answer 289

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

Question 290

List at least 5 uses of credit derivatives

Answer 290

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

Question 291

What is the upfront fee of a CDS at inception?

Answer 291

• 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

Question 292

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

Answer 292

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

Par - MV of Deliverable Obligations

Question 293

List the 2 types of credit events affecting CDS

Answer 293

1. Hard credit events
2. Soft credit events

Question 294

Describe the 2 types of credit events affecting CDS:

• Soft credit events

Answer 294

• 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

Question 295

Describe the 2 types of credit events affecting CDS:

• Hard credit events

Answer 295

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

Question 296

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

Answer 296

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

Question 297

List 3 main objectives of the CDS auction process

Answer 297

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)

Question 298

Describe the 6 steps in the CDS settlement timeline

Answer 298

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

Question 299

Describe characteristics of high yield bonds

Answer 299

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

Question 300

Describe unique aspects of SEC registration related to high yield bonds

Answer 300

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

Question 301

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

Answer 301

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

Question 302

List 5 key items included in a high yield bond offering

Answer 302

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

Question 303

List 3 types of syndication

Answer 303

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

Question 304

Describe 3 types of syndication:

• Back-stop deal

Answer 304

• Similar to a bought-deal, but longer timeframe (up to one week)

Question 305

Describe 3 types of syndication:

• Bought deal

Answer 305

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

Question 306

Describe 3 types of syndication:

• Underwritten (most common)

Answer 306

• marketed on a “best efforts” basis
• Underwriter has no obligation to complete the transaction

Question 307

Describe NAREIT

Answer 307

• 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

Question 308

Describe NCREIF

Answer 308

• 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

Question 309

List the at least 5 characteristics that affect real estate returns

Answer 309

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

Question 310

Describe the market and economic factors that affect real estate

Answer 310

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

Question 311

Describe the advantages of direct real estate investing

Answer 311

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

Question 312

Describe the disadvantages of direct real estate investing

Answer 312

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

Question 313

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

• Observations when adding RE to a stock/bond portfolio

Answer 313

• 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

Question 314

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

• Compared to stocks and bonds

Answer 314

• RE has low correlation
• RE has lower volatility than stocks
• Commercial rental income is often stable

Question 315

Describe how diversification is applied within real estate

Answer 315

• 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

Question 316

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

• Other SAA Considerations

Answer 316

• Direct RE may provide an inflation hedge
• RE improves Sharpe ratio
• Unsmoothed NCREIF returns should be used
• REITs offer higher liquidity

Question 317

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

• SAA

Answer 317

systematic factors affecting RE returns

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

Question 318

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

• TAA

Answer 318

RE tends to follow economic cycles (requires good forecasting)

Question 319

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

Answer 319

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)

Question 320

What is the problem with getting rid of LIBOR

Answer 320

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

• Will require adjustments ⇒ creates uncertainty around future contract values

Question 321

How are regulators around the world replacing LIBOR?

Answer 321

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

Question 322

Compare the US Securities Overnight Financing Rate to LIBOR

• Currency basis

Answer 322

• SOFR: USD only
• LIBOR: 5 different currencies

Question 323

Compare the US Securities Overnight Financing Rate to LIBOR

• Term structure

Answer 323

• SOFR: 1 day (overnight lending rate)
• LIBOR: 7 different maturities

Question 324

Compare the US Securities Overnight Financing Rate to LIBOR

• Credit risk

Answer 324

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

Question 325

Compare the US Securities Overnight Financing Rate to LIBOR

• Basis for rate

Answer 325

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