ILA-LPM E Flashcards

Question

List some quantitative methods for evaluating risk tolerance

Answer 1

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

Answer 2

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

Answer 3

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

Answer 4

* 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*

Answer 5

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)

Answer 6

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

Answer 7

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)

Answer 8

Sharpe ratio = SFRatio using the **risk-free rate R_F** for R_L SharpeRatio = [E(R_P) - R_F]/σ_P

Answer 9

**Standard normal probability approach**: choose portfolio with the lowest: Pr[R_p \< R_L] = Ø(-SFRatio)

Answer 10

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

Answer 11

* **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

Answer 12

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

Answer 13

* **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

Answer 14

* 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**

Answer 15

* **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)

Answer 16

* **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)

Answer 17

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

Answer 18

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

Answer 19

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

Answer 20

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!)**

Answer 21

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

Answer 22

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

Answer 23

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

Answer 24

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

Answer 25

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

Answer 26

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)

Answer 27

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)

Answer 28

standard deviation of the portfolio’s active return over time

Answer 29

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

Answer 30

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

Answer 31

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

Answer 32

**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

Answer 33

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**

Answer 34

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

Answer 35

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

Answer 36

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

Answer 37

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

Answer 38

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

Answer 39

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

Answer 40

* **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

Answer 41

* 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**

Answer 42

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

Answer 43

* **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**

Answer 44

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

Answer 45

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

Answer 46

**Goal:** maximize the lower bound return given the investor’s risk tolerance **Expected Return +/- 2σ**

Answer 47

* **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

Answer 48

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

Answer 49

Portfolios with the **least reinvestment risk** have the **least immunization risk**

Answer 50

* **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_!**

Answer 51

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

Answer 52

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

Answer 53

* **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**

Answer 54

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

Answer 55

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

Answer 56

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

Answer 57

* **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**

Answer 58

* **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)

Answer 59

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

Answer 60

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

Answer 61

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

Answer 62

* Does not account for the magnitude of losses

Answer 63

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

Answer 64

* 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

Answer 65

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)

Answer 66

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

Answer 67

**Basis** = Bond Cash Price - Futures Price * **Basis risk** = risk of unpredictable changes in the basis

Answer 68

* **Cross hedging** – hedged bond **_not equal to_** bond underlying the futures contract * Increases **basis risk**

Answer 69

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

Answer 70

Contract between two parties to exchange periodic interest payments based on a notional principal amount Interest Payment = Specified Interest Rate x Notional Amount

Answer 71

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

Answer 72

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

Answer 73

Option Duration = Duration of Underlying x Option Delta x (Price of Underlying/Price of Option Instrument)

Answer 74

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

Answer 75

* 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

Answer 76

* 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”

Answer 77

* 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

Answer 78

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

Answer 79

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

Answer 80

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

Answer 81

TWR = compound growth rate of $1 initially invested in the account ## Footnote *\*Must be calculated every time an external cash flow occurs*

Answer 82

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

Answer 83

**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)*

Answer 84

**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

Answer 85

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

Answer 86

* 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

Answer 87

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

Answer 88

**Current yield** – only measures coupon income Current Yield = Annual Dollar Coupon Interest/Price

Answer 89

* **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

Answer 90

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

Answer 91

**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*

Answer 92

* 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

Answer 93

* **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

Answer 94

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

Answer 95

**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

Answer 96

**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

Answer 97

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

Answer 98

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

Answer 99

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

Answer 100

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

Answer 101

**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)

Answer 102

**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

Answer 103

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

Answer 104

Liquidity Coverage Ratio = Cash Sources/Cash Needs (should be \>= 100%)

Answer 105

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

Answer 106

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

Answer 107

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

Answer 108

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

Answer 109

* 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

Answer 110

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

Answer 111

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

Answer 112

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

Answer 113

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

Answer 114

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

Answer 115

* 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

Answer 116

* Liquidity risk can also be born by policyholders (e.g. separate account products) * Creates **operationa**l 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

Answer 117

**liaison** between product actuaries and portfolio managers

Answer 118

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

Answer 119

* 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

Answer 120

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

Answer 121

* 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

Answer 122

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)

Answer 123

* **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”

Answer 124

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

Answer 125

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

Answer 126

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

Answer 127

* Impact is usually minimal

Answer 128

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

Answer 129

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

Answer 130

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

Answer 131

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

Answer 132

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

Answer 133

1. Discount securities 2. Coupon securities 3. Treasury Inflation-Protected Securities (TIPS) \*Treasury notes account for the vast majority outstanding

Answer 134

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

Answer 135

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

Answer 136

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

Answer 137

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

Answer 138

**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)

Answer 139

**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

Answer 140

**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

Answer 141

**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)

Answer 142

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

Answer 143

* (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**

Answer 144

* (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

Answer 145

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

Answer 146

**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

Answer 147

**The Secondary Market** * Multiple dealer, OTC (similar to Treasuries) * Mostly discount notes

Answer 148

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

Answer 149

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

Answer 150

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

Answer 151

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

Answer 152

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

Answer 153

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

Answer 154

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

Answer 155

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

Answer 156

* backed by revenue from specific projects

Answer 157

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

Answer 158

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

Answer 159

* 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**

Answer 160

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

Answer 161

* 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

Answer 162

**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

Answer 163

* **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)**

Answer 164

* 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

Answer 165

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

Answer 166

* 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

Answer 167

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

Answer 168

* guaranteed by one or more other companies

Answer 169

* 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

Answer 170

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

Answer 171

* 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

Answer 172

* 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

Answer 173

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

Answer 174

* **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

Answer 175

* 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

Answer 176

**Issuer default rate** – based on _number_ of defaulting issuers =No. Issuers that Default in the Year/Total Issuers at BOY

Answer 177

based on _amount_ of defaulted par

Answer 178

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

Answer 179

=Cumulative $ Value of All Defaulted Bonds/ (Cumulative $ Value of All Issues x Weighted Avg. No. Years Outstanding)

Answer 180

**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

Answer 181

**Event risk** – risk that a stockholder-driven event results in lower bond prices * Rating downgrades, increased leverage, etc. can result from M&A, etc.

Answer 182

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

Answer 183

* 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

Answer 184

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**

Answer 185

* 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

Answer 186

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

Answer 187

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

Answer 188

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

Answer 189

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

Answer 190

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

Answer 191

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

Answer 192

* **Repo rate** = interest rate agreed on between the borrower and lender Dollar Interest = (Dollar Principal) x (Repo Rate) x (Repo Term/360)

Answer 193

* **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

Answer 194

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

Answer 195

**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

Answer 196

**Quoted margin** reflects the market’s view on risk at issue * If the **required margin** \> quoted margin, trades at a discount (else premium)

Answer 197

Inverse floater coupons move inversely with the reference rate K **= K - L x (Reference Rate)**

Answer 198

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

Answer 199

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

Answer 200

**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

Answer 201

* 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

Answer 202

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

Answer 203

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

Answer 204

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

Answer 205

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

Answer 206

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

Answer 207

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

Answer 208

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

Answer 209

* 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

Answer 210

* **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**

Answer 211

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

Answer 212

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

Answer 213

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

Answer 214

1. Sale of property 2. Destruction of property (e.g. fire) 3. Borrower default 4. Partial principal prepayments 5. Refinancing ## Footnote **\*Prepayments can be rate-sensitive or rate-insensitive**

Answer 215

* 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

Answer 216

= annualized SMM =1 - (1 - SMM)¹² CPR = [Scheduled Balance - Actual Balance]/Schedule Balance

Answer 217

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

Answer 218

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

Answer 219

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

Answer 220

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

Answer 221

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

Answer 222

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**

Answer 223

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

Answer 224

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

Answer 225

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

Answer 226

* 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

Answer 227

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)

Answer 228

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

Answer 229

* **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)

Answer 230

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?

Answer 231

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

Answer 232

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

Answer 233

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

Answer 234

* Similar to credit support

Answer 235

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

Answer 236

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

Answer 237

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

Answer 238

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)

Answer 239

* 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

Answer 240

* 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

Answer 241

**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”):

Answer 242

**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

Answer 243

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%)

Answer 244

**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

Answer 245

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*

Answer 246

* **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

Answer 247

**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

Answer 248

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

Answer 249

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

Answer 250

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

Answer 251

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

Answer 252

* 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

Answer 253

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

Answer 254

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

Answer 255

swap transaction date

Answer 256

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)*

Answer 257

option to enter a swap at a future date

Answer 258

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

Answer 259

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

Answer 260

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

Answer 261

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

Answer 262

* All swaptions increase in value as interest rate volatility increases

Answer 263

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

Answer 264

**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

Answer 265

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

Answer 266

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**

Answer 267

* 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**

Answer 268

If a credit event triggers the CDS, the PS must pay the PB **Par - MV of Deliverable Obligations**

Answer 269

1. Hard credit events 2. Soft credit events

Answer 270

* 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

Answer 271

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

Answer 272

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

Answer 273

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)

Answer 274

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**

Answer 275

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

Answer 276

**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

Answer 277

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

Answer 278

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

Answer 279

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

Answer 280

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

Answer 281

**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

Answer 282

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

Answer 283

* 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*

Answer 284

* 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*

Answer 285

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

Answer 286

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

Answer 287

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

Answer 288

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

Answer 289

* 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

Answer 290

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

Answer 291

* 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

Answer 292

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

Answer 293

systematic factors affecting RE returns * Growth in consumption * Real interest rates * Term structure of interest rates * Unexpected inflation

Answer 294

RE tends to follow economic cycles (requires good forecasting)

Answer 295

**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)

Answer 296

**Problem: LIBOR affects $200 trillion of US derivatives and other variable rate contracts** * Will require adjustments ⇒ creates uncertainty around future contract values

Answer 297

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

Answer 298

* SOFR: USD only * LIBOR: 5 different currencies

Answer 299

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

Answer 300

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

Answer 301

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