SECURITIES Flashcards

Question

3.3 SECURITIES & DERIVATIVES | What is gains trading, and why is it an unsuitable investment activity?

Answer 1

* Gains trading is the purchase and subsequent sale of a security at a profit after a short holding period, while securities acquired for this purpose that cannot be sold at a profit are retained in the AFS or HTM portfolio. * Gains trading may be intended to defer loss recognition, as unrealized losses on debt securities in such categories do not directly affect regulatory capital and generally are not reported in income until the security is sold.

Answer 2

* The buying and selling of securities in the period between the announcement of an offering and the issuance and payment date of the securities. * A purchaser of a when-issued security acquires the risks and rewards of owning a security and may sell the when-issued security at a profit before having to take delivery and pay for it.

Answer 3

* Pair-offs are security purchase transactions that are closed-out or sold at or before the settlement date. * In a pair-off, an institution commits to purchase a security. Then, before the predetermined settlement date, the bank pairs-off the purchase with a sale of the same security. * Pair-offs are settled net when one party to the transaction remits the difference between the purchase and sale price to the counterparty. * Pair-offs may also involve the same sequence of events using swaps, options on swaps, forward commitments, options on forward commitments, or other off-balance sheet derivative contracts.

Answer 4

* Extended Settlement is the use of a securities trade settlement period in excess of the regular-way settlement period. * Regular-way settlement for U.S. Government and Federal agency securities (except mortgage-backed securities and derivative contracts) is one business day after the trade date. * Regular-way settlement for corporate and municipal securities is three business days after the trade date, and for mortgage-backed securities it can be up to 60 days or more after the trade date. * The use of a settlement period in excess of the regular-way settlement period to facilitate speculation is considered a trading activity.

Answer 5

* Offered by a dealer to allow an institution that has entered into a when-issued trade or a pair-off (which may include an extended settlement) that cannot be closed out at a profit on the payment or settlement date to hold its speculative position until the security can be sold at a gain. * The institution purchasing the security pays the dealer a small margin that approximates the actual loss in the security. * The dealer then agrees to fund the purchase of the security by buying it back from the purchaser under a resale agreement. * Any securities acquired through a dealer financing technique such as a repositioning repurchase agreement that is used to fund the speculative purchase of securities should be reported as trading assets.

Answer 6

* Involves the sale of a security to a broker or dealer at a price above the prevailing market value and the simultaneous purchase and booking of a different security, frequently a lower rated or quality issue or one with a longer maturity, at a price above its market value. * The dealer is reimbursed for losses on the purchase from the institution and ensured a profit. * Such transactions inappropriately defer the recognition of losses on the security sold and establish an excessive cost basis for the newly acquired security. * Such transactions are prohibited and may be in violation of 18 U.S.C. Sections 1001-False Statements or Entries and 1005-False Entries.

Answer 7

* The sale of a security that is not owned. * The purpose of a short sale generally is to speculate on a fall in the price of the security. * Short sales should be conducted in the trading portfolio * A short sale that involves the delivery of the security sold short by borrowing it from the depository institution's AFS or HTM portfolio should not be reported as a short sale. * Instead, it should be reported as a sale of the underlying security with gain or loss recognized in current earnings.

Answer 8

* Basis risk * Interest rate risk (primary source) * Commodity-Price risk * Yield Curve risk

Answer 9

• Market risk is the possibility that an instrument will lose value due to a change in the price of an underlying instrument, change in the value of an index of financial instruments, changes in various interest rates, or other factors • Frequently, an instrument will increase a bank's market risk due to price volatility, embedded options, leverage factors, or other structural factors. • The three principal types of market risk are: >> price risk, >> interest rate risk, and >> basis risk.

Answer 10

* Price risk is the possibility that an instrument's price fluctuation will unfavorably affect income, capital, or risk reduction strategies. * Price risk is usually influenced by other risks. * For example, a bond's price risk could be a function of rising interest rates, while a currency-linked note's price risk could be a function of devaluation in the linked currency.

Answer 11

* Yield curve risk is the possibility that an instrument's value will fluctuate in response to a nonparallel yield curve shift. * Yield curve risk is a form of interest rate risk.

Answer 12

* Basis risk is the possibility that an instrument's value will fluctuate at a rate that differs from the change in value of a related instrument. * For example, three-month Eurodollar funding is not perfectly correlated with Treasury bill yields. * This imperfect correlation between funding cost and asset yield creates basis risk.

Answer 13

* Credit risk is the possibility of loss due to a counterparty's or issuer's default, or inability to meet contractual payment terms. * The amount of credit risk equals the replacement cost (also referred to as current exposure) of an identical instrument. * The replacement cost is established by assessing the instrument's current market value rather than its value at inception.

Answer 14

• Interest rate risk is the possibility that an instrument's value will fluctuate in response to current or expected market interest rate changes.

Answer 15

* Liquidity risk is the possibility that an instrument cannot be obtained, closed out, or sold at (or very close to) its economic value. * As individual markets evolve, their liquidity will gradually change, but market liquidity can also fluctuate rapidly during stress periods. * In some markets, liquidity can vary materially during a single day. * Some markets are liquid for particular maturities or volumes, but are illiquid for others * For example, the Eurodollar futures market is liquid for contracts with maturities up to four years, but liquidity decreases for greater maturities (although maturities of up to 10 years are listed).

Answer 16

* Operational risk is the possibility that inadequate internal controls or procedures, human error, system failure or fraud can cause losses. * Operating risk can result in unanticipated open positions or risk exposures that exceed established limits.

Answer 17

* Legal risk is the possibility that legal action will preclude a counterparty's contractual performance. * Legal risk may occur when a contract or instrument violates laws or regulations. * Legal risk may also occur when a law or regulation prohibits a counterparty from entering into a particular contract, or if an individual is not authorized to execute transactions on behalf of the counterparty. * Banks should ensure that all agreements are enforceable and that counterparties can legally enter into specific transactions. 3.3 SECURITIES & DERIVATIVES What is interconnection risk? • Interconnection risk is the possibility of loss due to changes in interest rates, indices or other instrument values that may or may not be held by the investor. • Cash flows associated with an instrument may be directly or indirectly tied to a number of other rates, indices or instrument values. • These interconnections frequently involve cross-border and cross-market links and a wide range of individual financial instruments. • For example, a U.S. dollar denominated structured note may have a coupon formula linked to a currency exchange rate. • Structured notes with coupon payments linked to the relationship between the Mexican peso and the U.S. dollar fell substantially in value when the peso fluctuated in the wake of the assassination of a Mexican presidential candidate.

Answer 18

* Settlement risk is the possibility of loss from a counterparty that does not perform after the investor has delivered funds or assets (before receiving the contractual proceeds). Settlement risk may result from time differences between foreign counterparties, delivery that is not synchronized with payment, or method of payment delays. Few transactions are settled on a real-time basis, and any delay in receiving funds or assets after delivering funds or assets will create settlement risk. * The most famous settlement risk example occurred in the foreign exchange markets. German regulators closed Bankhaus Herstatt after it had received deutschemarks on its foreign exchange trades, but before it had sent out its currency payments. Settlement risk is sometimes referred to as Herstatt risk.

Answer 19

* Effective investment activity oversight requires accurate risk measurement. * Without periodic assessments, management can not determine the success of its investment strategies. * Further, the board can not determine if management has achieved the board's goals or complied with its policies.

Answer 20

• The board should adopt policies that establish guidelines for management and periodically review management's performance. • The board should: >> Approve broad goals and risk limits, >> Adopt major investment and risk management policies, >> Understand the approved investment activities, >> Ensure competent investment management, >> Periodically review management's investment activity, >> Require management to demonstrate compliance with the board's goals and risk limits, and >> Mandate an independent review program and review its findings

Answer 21

• Management is responsible for daily oversight of all investment activity. • Management should: >> Establish policies, procedures, and risk limits to achieve the board's goals, >> Implement operational policies that establish a strong internal control environment, >> Understand all approved investment activities and the related risks, >> Identify, measure, monitor, and control investment activity risks, >> Report investment activity and risks to the board;, >> Ensure that its staff is competent and adequately trained, and >> Adhere to securities broker/dealer selection policies

Answer 22

* Overall strategic goals, * Capital position, * Asset/liability structure, * Earnings composition, and * Competitive market position.

Answer 23

Implements Section 24 of the Federal Deposit Insurance Act.

Answer 24

* The activity presents no significant risk to the deposit insurance fund, and * The bank complies with the FDIC's capital regulations.

Answer 25

* Dominion Bond Rating Service Ltd., * Fitch, Inc., * Moody's Investors Service, and * Standard & Poor's Division of the McGraw Hill Co. Inc.

Answer 26

The impairment is classified Loss

Answer 27

The impairment is classified Substandard at amortized cost.

Answer 28

The defaulted debt securities will be classified Loss, and the impairment will be classified Substandard at fair value.

Answer 29

* Investment quality debt securities with "temporary" impairment - no classification * Investment quality debt securities with "other than temporary" impairment - Impairment is taken as a loss * Impairment * Sub-investment quality debt securities with "temporary" impairment - amortized at Amortized Cost * Sub-investment quality debt securities with "other than temporary" impairment, including defaulted debt securities - fair value and impairment take as a loss. * NOTE: Impairment is the amount by which amortized cost exceeds fair value.

Answer 30

``` • Moody’s >> Aaa >> Aa, >> A+ or A, >> Baa-1 or Baa • S&P’s >> AAA, >> AA, >> A, >> BBB ```

Answer 31

* The change in the market value over the measurement period * The coupon received * The reinvestment interest on the cash flows received during the measurement period

Answer 32

• A type of fixed-income security where the holder is only entitled to receive regular cash flows that are derived from incoming principal repayments on an underlying loan pool • The loan is often a pool of mortgages in the form of a mortgage-backed security (MBS). • The security is created by splitting a mortgage-backed security into its interest and principal payments • The principal payments create a string of cash flows which are sold at a discount to investors • These investors will receive the principal portions of the monthly mortgage payments from the underlying pool of loans. • The yield on a PO strip depends on the prepayment speed of the underlying loan >> The faster the principal is repaid, the higher the yield an investor will receive. >> Since the investor benefits from faster repayment speeds, he or she is protected from contraction risk. >> This means that, unlike a usual bond, the investor will benefit from decreases in the interest rate. **Not the case for Treasury Strips though.

Answer 33

• The interest portion of mortgage, Treasury or bond payments, which is separated and sold individually from the principal portion of those same payments. • The periodic payments of several bonds can be "stripped" to form synthetic zero-coupon bonds. • Also, an IO strip might be part of a larger collateralized mortgage obligation (CMO), asset-backed security (ABS) or collateralized debt obligation (CDO) structure. • Financial engineers, such as Wall Street dealers, frequently strip and restructure bond payments in an effort to earn arbitrage profits. • Zero-coupon Treasury strips are an important building block in many financial calculations and bond valuations. >> For example, the zero coupon or spot-rate Treasury yield curve is used in option-adjusted spread (OAS) calculations and for other valuations of bonds with embedded options.

Answer 34

* A type of mortgage-backed security in which principal repayments are organized according to their maturities and into different classes based on risk. * A collateralized mortgage obligation is a special purpose entity that receives the mortgage repayments, and owns the mortgages it receives cash flows from (called a pool). * The mortgages serve as collateral, and are organized into classes based on their risk profile. * Income received from the mortgages is passed to investors based on a predetermined set of rules, and investors receive money based on the specific slice of mortgages invested in (called a tranche) * Rates Rise, Value Increases * Rates Fall, Value Decreases

Answer 35

* Floating-rate instruments with coupon payments based on a specific point on the yield curve. * Deleveraged Note - coupon rate will adjust by a fraction of the change in the underlying index: * Attractive when rates expected to remain stable or decrease * Market risk increases as leverage factor approaches 1.0 >> Example of a deleveraged note: > Deleveraged: 0.50 X 10-year CMT + 150 bps

Answer 36

* Floating-rate instruments with coupon payments based on a specific point on the yield curve. * Leveraged Note - coupon rate will adjust by a multiple of the change in the underlying index (LIBOR, COFI, CMT) * Attractive when rates expected to increase >> Examples of a leveraged note: > Leveraged: 1.50 X 3-month LIBOR + 100 bps

Answer 37

* Very price sensitive under declining rate scenarios * Pre-payments impact the price of both instruments * May support CFs / provide a CF hedge * Positive Convexity - Option Free Instrument * Negative Convexity - Embedded Options in Instrument

Answer 38

* Re-pricing Risk * Basis Risk, and * Option Risk

Answer 39

* Basic – provides for the counterparties to exchange variable-rate cash flows based upon different market indices. These agreements can be used to reduce basis risk for a balance sheet that has rates on assets and liabilities tied to different indices or different maturities of the same index. * Amortizing – has a notional amount that declines (amortizes) over the life of the agreement and may be used to hedge amortizing assets or to replicate cash flows of mortgage products. Usually these are fixed at inception. * Accreting – has a notional principal that increases over the life of the agreement and could be used to hedge the increasing interest rate risk in a construction loan because the loan balance increases during the funding of a construction project. * Forward – is a swap that has not reached its effective date; allows an institution to initiate a swap with a delayed start. These swaps can be used to hedge debt refinancings or anticipated debt issuances. These are based on forward interest rates. * Swaptions – is a contract that combines an option and a swap whereby one party has an option (the right, not an obligation) to enter into an interest-rate swap or terminate an existing swap at some future date.

Answer 40

• Pay-fixed for variable swap >> Short position on fixed rate, >> Long position on floating rate • Value of the swap equals difference between the NPV of the payment streams of the two sides • Typically use the Treasury curve at a point equal to maturity plus swap spread • Though NPV of fixed and floating initially same, likely changes over time

Answer 41

* Caps – equivalent to series of put options. When the underlying index exceeds the strike rate, the seller pays the difference on the notional amount. * Floors – equivalent to a series of call options. When the underlying index is less than the strike rate, the seller pays the difference on the notional amount. * Corridors – strategy used to protect the buyer from a modest rate increase. A corridor is a combination of a long cap and a short cap. The cap is purchased to reduce exposure to rising rates. Another cap, with a higher strike rate, is sold to reduce the expense of the long cap. * Collars – combination of a cap and a floor. An investor buys a cap and sells the floor to reduce the cost of the cap.

Answer 42

* Proximity of the underlying index to the strike * Remaining term to maturity * Volatility of the underlying index

Answer 43

• Delta – the change in the value of the option (cap or floor) resulting from a small change in the underlying cash instrument (similar to duration). >> Often used to determine how many contracts to purchase. >> Contracts with higher deltas will have greater price sensitivities to changes in the underlying instrument. • Gamma – the change in the delta given a change in the underlying index (similar to convexity). >> Gamma risk is at its greatest when the option is at-the-money. • Theta – the loss of a contract’s value due to the passage of time. • Vega – the change in an agreement’s price resulting from a change in the volatility of the underlying index. >> Vega is always positive because option values increase as volatility rises.

Answer 44

• Futures – standardized, exchange-traded contracts obligating one party to buy, and the other to sell, a specific asset for a fixed price at a future date. • Forwards – a contract obligating one party to buy, and the other to sell, a specific asset for a fixed price at a future date. >> These are bought and sold over the counter.

Answer 45

* Forward Yields – derived from spot yields and indicate the market’s overall expectations for future level of rates and the entire yield curve. * Implied Forward Rates – can give market participants important information about expectations of the direction of future rates. * Forward Rates – critical in determining prices of many hedging instruments, e.g. derivatives, and can provide protection against future volatility in rates or prices. * Option Adjusted Spread – investor can use either the a) spot rate or b) forward yields for this calculation. This is a spread to help determine the relative value for a security that has embedded options, e.g. a MBS.

Answer 46

• Prices move in the same direction as bonds, i.e. rising rates yields lower prices • Cash price is usually different from price in futures market, difference called basis • Factors affecting basis include: >> cost of carry, >> economic factors, >> perception of rate movements, and >> volatility of interest rates. • Principal risk is that basis may change from time hedge is initiated until termination

Answer 47

* Indexing | * Immunization

Answer 48

Assembling a portfolio closely resembling the risk and return characteristics of a preferred market index.

Answer 49

A bond portfolio structured so that interest rate risk characteristics (Macaulay duration) match those of the liability stream. Referred to as duration matching and requires frequent calculation and rebalancing.

Answer 50

* Interest rate expectations strategy * Individual security selection strategy * Yield Curve Strategies * Yield Spread Strategies * Cash Flow matching strategies

Answer 51

To maximize return based on a forecast of future interest rate movements (consists of adjusting duration of the bond portfolio.)

Answer 52

The attempt to identify individual instruments that will outperform other similarly rated instruments

Answer 53

It involves positioning fixed income portfolios to capitalize on or protect against expected changes in the shape of the treasury yield curve: >> Bullet portfolio >> Laddered portfolio >> Barbell portfolio

Answer 54

It involves the positioning of fixed-income portfolios to profit on expected changes in yield spread between sectors of the bond market (ex: spread between top quality and lower quality bonds narrow as business conditions improve)

Answer 55

An attempt to match the cash flow requirements of a banks liabilities with the cash flow provided by specific instruments

Answer 56

It is constructed so the maturity of the securities is highly concentrated on one point of the yield curve

Answer 57

It spreads instruments across the maturity spectrum and provides regular cash flows

Answer 58

It concentrates instruments at the short term and long term extremes of the maturity spectrum

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SECURITIES Flashcards

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