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CFA Level II Fixed Income > New - Reading 44 - Valuation and Analysis: Bonds with Embedded Options > Flashcards

New - Reading 44 - Valuation and Analysis: Bonds with Embedded Options Flashcards

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1
Q

What is the most common embedded option found within a bond?

A

A call option

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2
Q

Why is a Call Option considered a issuer option?

A

B/c the issuer decides whether to call the bond or not

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3
Q

What is Bermudan style call option?

A

an option that can be exercised only on a predetermined schedule of dates after the end of the lockout period

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4
Q

Why is a Put Option considered an investor option?

A

B/c the investor has the right to exercise the option at their discretion

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5
Q

What is an Extentible Bond?

A

At maturity, the holder has the right to keep the bond for a number of years after maturity, possibly with a different coupon.

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6
Q

What is a Sinking Fund Bond (ie sinker) ?

A

a bond which requires the issuer to set aside funds over time to retire the bond issue, thus reducing credit risk

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7
Q

What is The Value of a Callable Bond equal to?

A

Value of Callable Bond =

Value of Straight Bond - Value of Issuer Call Option

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8
Q

What is The Value of Issuer Call Option for a callable bond?

A

Value of issuer call option =

Value of Straight bond - Value of Callable Bond

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9
Q

What is The Value of a Putable Bond?

A

Value of Putable Bond =

Value of Straight Bond + Value of investor put option

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10
Q

What is The Value of Investor Put Option on a putable bond?

A

Value of investor put option =

Value of putable bond - Value of Straight Bond

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11
Q

Does the value of any embedded option increase or decrease with increased volatility?

A

Whether a put or a call, the value increases as volatility increases

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12
Q

Does the value of a Call Option increase as the yield curve flattens?

A

It increases.

When the yield curve is steep, it means the 1 yr forward rate on the interest rates tree are high and provides few opportunities to call a bond. As the curve flattens, more nodes on the tree have lower rates presenting more opportunities to be call -> Inceasing their value

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13
Q

Why are put options within bonds considered a hedge against rising interest rates for investors?

A

B/c as interest rates rise, the value of a bond decreases. It doesn’t decrease as much as it otherwise would because the put limits the value decline. (it creates a floor through which the price will not fall below b/c the investor would put the bond back on the issuer)

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14
Q

What is The Value of a Put Option as the yield curve flatten or inverts?

A

Decreases

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15
Q

What are the 2 approaches to valuing bonds that are subject to default risk?

A
  1. To increase the discount rates above the default free rates to reflect default risk. (This is the industry standard)(This is called the Z-Spread)
  2. By making the default probabilities explicit- meaning assigning probablities to each time period going forward
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16
Q

Describe what Duration is ?

A

It measures the sensitivity of the bond’s full price to changes in the bond’s ytm or to changes in benchmark interest rates

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17
Q

What is the only valid duration choice to use for bonds with embedded options?

A

Effective Duration

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18
Q

How do you calculate Effective Duration?

A
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19
Q

What does an effective duration on 1.97 indicate?

A

That a 100bp increase in interest rates would decrease the value of a bond by 1.97%

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20
Q

Is the duration of a callable bond >, =, < that of a straight bond?

A

≤

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21
Q

Is the duration of a puttable bond >, =, < that of a straight bond?

A

≤

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22
Q

What are the approximate effective durations for each type of bond listed below?

Cash

Zero-coupon bond

Fixed Rate Bond

Callable Bond

Putable Bond

Floater (Libor flat)

A

Cash -> 0

Zero Coupon -> ≈ Maturity

Fixed Rate Bond -> < Maturity

Callable Bond -> ≤Duration of Straight bond

Putable Bond -> ≤Duration of Straight bond

Floater(Libor flat) -> ≈Time in yrs to reset

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23
Q

Why is the price senstivity of bonds with embedded options not symmetrical?

A

If the option is in the money, positive and negative interest rate changes will not have the same effect

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24
Q

What are One Sided Durations ?

A

Effective durations when interest rates go up or down, which are better at capturing the interest rate sensitivity of bonds with embedded options that do not react symmetrically to positive and negative changes in interest rates of the same magnitude.

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25
Q

What are **Key Rate Durations? **

A

Sensitivity of a bond’s price to changes in specific maturities on the benchmark yield curve. Also called partial durations.

26
Q

What risk does using Key Rate Duration help in indentifying?

A

Shaping Risk (ie the curvature of the yield curve)

27
Q

What is Effective Convexity?

A

Sensitivity of duration to changes in interest rates.

28
Q

How do you calculate Effective Convexity?

A
29
Q

What type of convexity does a putable bond have?

A

Always positive

30
Q

When does the effective convexity of a callable bond become negative?

A

when the call option is near the money

31
Q

What is a Capped Floater?

A

Floating-rate bond with a cap provision that prevents the coupon rate from increasing above a specified maximum rate. It protects the issuer against rising interest rates.

32
Q

How is The Value of a Capped Floater calculated?

A

Value of Capped Floater =

Value of Straight Bond - Valued of embedded cap

33
Q

What is a** Ratchet Bond?**

A

Are floating rate bonds with both issuer and investor options

  • Like floaters the coupon is reset periodically
  • A capped floater protects the issuer from rising interest rates
  • Whenever the coupon is reset, the investor has the right to put the bonds back to the issuer at par. Thus, protecting the investor
34
Q

What is a** Floored Floater?**

A

Floating-rate bond with a floor provision that prevents the coupon rate from decreasing below a specified minimum rate. It protects the investor against declining interest rates.

35
Q

How is **The Valued of a Floored Floater **calculated?

A

Value of floored floater =

Value of Straight Bond + Value of Embedded Floor

36
Q

What is a Convertible Bond ?

A

Bond with an embedded conversion option that gives the bondholder the right to convert their bonds into the issuer’s common stock during a pre-determined period (conversion period) at a pre-determined price (conversion price).

37
Q

What benefits do Convertible Bonds offer for both investors and issuers?

A
  • Investors:
    • Accept lower coupon for otherwise identical non-convertible bond so they can participate in the potential upside through the conversion mechanism
  • Issuer:
    • Benefits from paying a lower coupon
    • In case of conversion, then no longer as to repay the debt that was converted to equity
38
Q

What is a Forced Conversion?

A

For a convertible bond, when the issuer calls the bond and forces bondholders to convert their bonds into shares, which typically happens when the underlying share price increases above the conversion price.

39
Q

What is the Conversion Value and how is it calculated?

A

For a convertible bond, the value of the bond if it is converted at the market price of the shares. Also called parity value.

= Underlying price * Conversion Ratio

40
Q

What is the minimum value of a convertible bond?

A

The greater of :

  • The conversion value
  • The value of the underlying option free value
41
Q

What is the Market Conversion Premium per Share & how is it calculated?

A

For a convertible bond, the difference between the market conversion price and the underlying share price, which allows investors to identify the premium or discount payable when buying a convertible bond rather than the underlying common stock.

= Market Conversion Price - Underlying Share Price

42
Q

How do you calculate the Market Conversion Price?

A
43
Q

What is the **Market Conversion Premium Ratio ** and how is it calculated?

A

For a convertible bond, the market conversion premium per share expressed as a percentage of the current market price of the shares.

44
Q

When is the only time an investor will put the bond back to the issuer?

A

when the present value of the bond’s future cash flows is lower than the put price

45
Q

What are Death-put bonds?

A

a bond having an estate put or survivor’s put option, which grants the heirs of a deceased bondholder to redeem the bond at par valuw

46
Q

What does a high convexity value tell us?

A

That the bond is sensitive the bond price is to decreased interest rates & less sensitive to increasing rates

47
Q

Explain the up-duration and down duration for a callable bond…..

A

The one-sided up-duration is higher than the one-sided down-duration

**This is b/c the callable bond is more sensitive to interest rates rises than to interest rate declines

48
Q

Explain the up-duration and down-duration for a putable bond…..

A

The one-sided down-duration is higher than the one sided up-duration.

*This is b/c the putable bond is more sensitive to interest rates declines than to interest rate rises*

49
Q

Describe the price movements of a bond that has positive convexity.

A

The price of a bond rises slightly more when interest rates move down than it declines when interest rates move up by the same amount

50
Q

Given the below data, calculate the Conversion Value….

A

Conversion Value = Price * Conversion Ratio

= 33 * 25 = $82.50

51
Q

Given the below data, calculate the Minimum Value….

A

Minimum value of the greater of:

  1. conversion value
  2. straight value (value of security without conversion option)

Conversion value = 33 * 25 -> $825.00

Straight Value = $98.19

$98.19 is the minimum value

52
Q

Given the below data, calculate the Market Conversion Price….

A

= Market Price of Convertible Security

Converstion Ratio

= 1,065 / 25 = $42.50

53
Q

Given the below data, calculate the Market Conversion Premium Per Share….

A

= Market Conversion Price - Current Market Price

Market Conversion Price = 1,065 / 25 -> $42.60

Current Price = 33

42.60 - 33.00 -> $9.60

54
Q

Given the below data, calculate the Market Conversion Premium Ratio….

A

= Market Conversion Premium Per Share

Market Price of Stock

= $9.60 / $33.00 = 29.1%

55
Q

Given the below data, calculate the Favorable Income Differential Per Share….

A
56
Q

Given the below data, calculate the Premium Payback Period….

A
57
Q

How is downside risk measured for a convertible bond?

A

Premium over straight value

58
Q

Using a options based approach, buying a non-callable/non-putable convertible bond is equivalent to what?

A
  • buying a noncallable/nonputable straight security
  • &
  • buying a call option on the stock where the number of shares that can be purchased with the call option is equal to the conversion ratio
59
Q

How d you calculate the value of a non-callable/non-putable convertible security?

A

= Straight Value + Value of the call option on the stock

60
Q

How d you calculate the value of a callable convertible bond?

A

= Straight Value

+ Value of the call option on the stock

  • value of the call option on the bond
61
Q

How d you calculate the value of a callable & putable convertible bond?

A

= Straight value

+ value of call option on the stock

  • value of call option on the bond

+ value of put option on the bond

CFA Level II Fixed Income (5 decks)

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