Thuật ngữ Thuật ngữ

• Mua Trái phiếu è Là hình thức cho bên bán trái phiếu vay và nhận lãi định kỳ • Đơn vị phân phối trái phiếu (Investment bank)

• Trái phiếu chính phủ / doanh nghiệp (Government / Corporate bond) • Đăng ký phát hành với Ủy ban chứng khoán (Registering with securities regulators)

• Kỳ hạn phát hành (Maturity) • Bảo lãnh phát hành (Underwriting)

• Lãi suất phát hành (Coupon rate) • Hoa hồng môi giới bán trái phiếu (Commission)

• Đấu giá (Auction) • Nhà đầu tư chuyên nghiệp (Qualified investors)

• Kỳ hạn còn lại (Tenor) • Xếp hạng tín nhiệm (Credit rating)

• Tài sản đảm bảo (Collateral) • Trái phiếu kém chất lượng (Junk bonds)

• Trái phiếu phát hành ra công chúng (Public offerings bonds)

• Trái phiếu phát hành riêng lẻ (Private placement bonds)

1 Defining elements (Lecture 1)

2 Issuance, Trading, and Funding (Lecture 2)

CFA 4 3 Fixed Income Valuation (Lecture 3, 4, 5)

Fixed Income Fixed Income

4 Asset Backed Securities (Lecture 6, 7)
• Reference : Textbook, Reading 39 - 44

5 FI Risk and Return (Lecture 8, 9)

6 Credit Analysis (Lecture 10)

 Learning
Objectives
1. Basic features of a fixed-income security

2. Content of a bond indenture,

Fixed-Income : Lecture 1 compare affirmative and negative covenants
Bond Indentures, Regulation, and Taxation 3. Legal, regulatory, and tax effect on the issuance
and trading

• Reference : Textbook, Reading 39

1. Basic features of a fixed-income security: 1.1. Issuers of Bonds:

Sovereign national governments

01 04 Corporations

Non-sovereign governments 02 Issuers 05 Supranational entities

Quasi-government entities 03 06 Special purpose entities (SPEs)

 Issuer Issuer Issuer Issuer

Bondholder Bondholder Bondholder Bondholder

1.2. Bond Maturity: 1.3. Par value: 1.4. Coupon Payments: 1.5. Currencies:
• Maturity date: The date on which the principal • Principal amount that will be repaid at maturity • Coupon rate: Annual percentage of par • Single-currency bond: interest
is to be repaid value that will be paid to bondholders payments and principal payment in
• Premium: Selling more than Par same currency
• Tenor: Time remaining until maturity • Frequency: Annually, semiannual, quarterly,
• Discount: Selling less than Par monthly, … • Dual-currency bond: interest
• Perpetual bonds: Have no maturity date payments in one currency, and
• At par: Selling same as Par • Plain vanilla: Bond with fixed coupon rate principal payment in another currency
• < 1 year : Money market securities
• > 1 year : Capital market securities • Pure discount: Sold at discount to par value • Currency option bond: Option to
choose currency of payments

Example: 2. Content of a bond indenture, compare affirmative and negative covenants:

Finding basic features of this bond coupon

Issuer Bondholder
(Borrower) (Lender)

Bond indenture = Legal contract

Bond covenants = Provisions in Legal contract

Affirmative covenants Negative covenants

Actions the borrower promises to perform Prohibitions on the borrower

• Make timely interest & principal payments, • Restrictions on asset sales

insure and maintain assets, comply with laws
• Negative pledge of collateral
• Examples: cross-default and pari passu
• Restrictions on additional borrowings
3. Legal, regulatory, and tax effect on the issuance and trading: 3. Legal, regulatory, and tax effect on the issuance and trading:

Countries: US, China, Japan

Issuing entities Sources of repayment

Issuer Trading market Currency • Legal information about the issuer • Sovereign Gov bonds: Tax

Domestic bonds • SPEs / SPVs • Non-Sovereign Gov bonds:

=> Securitized bonds Tax, Fees, Specific projects
Foreign bonds
• Corporate bonds: Cash Flows
Eurobonds from Operations
Bank A
Bondholders
Customers
• SPEs: Cash Flows from
Global bonds Financial assets

Bank A SPE

3. Legal, regulatory, and tax effect on the issuance and trading: 3. Legal, regulatory, and tax effect on the issuance and trading:

Taxation of Bond Income

Ordinary income
Collateral Credit enhancements
• Most often, taxed at the normal rate
Internal External
Types Collateral
• US Municipal governments bonds: tax exempt (nation & that state)
Unsecured bonds / • Overcollateralization • Surety bonds
No collateral
Debenture
• Cash reserve fund • Bank guarantees Capital gains income
Equipment trust
Equipment • Excess spread account • Letter of credit • Taxed at lower rate than ordinary income. Even lower if that is long-term capital gains
certificates

Collateral trust • Tranches (waterfall structure)

Stock, other bonds Original issue discount (OID) bonds
bonds
Mortgage-backed • A portion from par is treated as taxable interest income each year
Mortgages
security
Loans
Covered bonds
(no SPE created)
 Learning
Objectives
1. How cash flows of fixed-income are structured

2. Effect of contingency provisions on timing, nature of

Fixed-Income : Lecture 1 (cont.) cash flows, and benefit of borrower/lender
Bond Cash Flows and Contingencies

• Reference : Textbook, Reading 39

1. How cash flows of fixed-income are structured: 1. How cash flows of fixed-income are structured:
1.1. Fixed – coupon structure: Bond: $1,000 par value, 5% coupon rate, 5 year 1.2. Sinking fund provisions:

Bullet (Balloon) Year 1 2 3 4 5

Total Issue: $300 million, 20 year
Payment $50 $50 $50 $50 $50 + $1,000 Sinking fund provisions: $20 million every year, beginning in 6th year
Interest (coupon) payments are made over the life of the bond, and
Principal
principal value is paid with the final interest payment at maturity remaining
$1,000 $1,000 $1,000 $1,000 $0

Year 0 1 2 3 4 5 6 7 8 (…)
Fully amortizing Year 1 2 3 4 5
Payment $231 $231 $231 $231 $231 Principal $20m $20m $20m
Equal periodic payments until maturity, including interest and part of
Principal redeemed
principal. The principal is fully paid off at the last periodic payment remaining
$819 $629 $429 $220 $0

Advantages Disadvantages
Partially amortizing Year 1 2 3 4 5
Payment $195 $195 $195 $195 $195 + $200
Periodic payments until maturity, and last periodic payment include • Reduces the risk of default of issuer • Investors face investment risk
Principal
$855 $703 $544 $376 $0
remaining unamortized principal amount remaining
• Issuer repurchase bonds at below market prices
(with call option)
1. How cash flows of fixed-income are structured: 2. Effect of contingency provisions on timing, cash flows, benefit of participants
1.3. Other Coupon Structures: Contingency provisions (embedded options): actions that may be taken if an event occurs

Contingency
Type of coupon payment Coupon received Notes Description Timing Benefit Yield Others
provision

Fixed coupon Fixed Option-free No contingency provisions Base

• LIBOR • American (anytime)
Market reference rate (MRR) Right of issuer to redeem Lockout period
Floaters (FRN) • Cap <> Floor Higher • European (on specified date)
+ margin (basic points) Call option bond issued at (1st call date, Issuer
• Inverse floater yield • Bermuda (coupon payment dates
a specific price 1st par call date)
after 1st call date)
Step-up coupon Increase overtime as a predetermined schedule Call option
Right of bondholder to sell
Credit-linked coupon Inversely related to issuers credit rating Put price > Fair Lower
Put option bond back to issuer at Bondholder
value yield
prespecified price
Payment-in-kind coupon From more bonds issued High yield
Option of bondholder to Conversion
Deferred coupon Don’t begin until a period Convertible Lower • Hybrid security
exchange the bond for a value > Par Bondholder
option yield • Conversion price, ratio, value
• Most common: Inflation specific number of shares value
• Inflation linked bonds: Right of bondholder to buy
Indexed-linked coupon Based on an index Given price >
Principal protection, annuity, Warrants shares at a given price & Bondholder • Young companies
Share price
zero-coupon, interest, capital given period

Homework:

Using BA calculator to find each year: Balance, Principal part, and Interest (Coupon) part of below bond

• $5,000 par value,

• 6% coupon rate,
Fixed-Income : Lecture 2
• 4-year maturity, Types of Bonds and Issuers
• Principal value unamortized at maturity : $500
• Reference : Textbook, Reading 40
 1. Classifications of global fixed-income markets:
Learning
• Gov & Gov related organizations • Investment grade bonds (>= …)
Objectives •
•
Supranational entities
Corporations
• Junk bonds (< …) • < 1 year : Money market securities
• > 1 year : Capital market securities
• SPEs
Type of Issuers Credit quality Maturity
1. Classifications of global fixed-income markets

2. Primary & secondary markets for bonds

3. Sovereign government bonds,

Non-sovereign government bonds,
Others Coupon structure
Quasi-government bonds,
Supranational bonds % Fixed, floater, step-up,
• Inflation-linked bonds credit-linked, payment-in-
• Taxable & tax-exempt kind, deferred,
bonds index-linked bonds
Geography Currency denomination
• Bond’s cash flows determined by
• Domestic, foreign, global, euro bonds interest rates of bond’s currency
• Developed & emerging markets • Mostly in USD or Euros

2. Primary & secondary markets for bonds: 2.1. Primary markets:

Public Offerings Typically done with the help of an investment bank (underwriter)

Underwritten offerings
Select underwriter (Investment bank) Investment bank or group of investment
Issuer Investors Investors banks purchase the entire bond issue
Determining funding needs
Best efforts offerings
Structuring the debt security
Investment bank sell the bonds on a
Creating the bond indenture commission basis
Primary Secondary
Naming a bond trustee
market market
Shelf Registration
Registering with securities regulators
Once the issuer has registered with the regulators,
Assessing demand and pricing (Grey market) additional bonds can be issued when needed

Selling the bonds Auctions

• Government bonds
• Majority of purchases made by primary dealers
2.1. Primary markets: 2.2. Secondary markets:

Private Placement Exchanges

Seller Buyer
• Direct
Non-underwritten Unregistered

Bonds Over-The-Counter (OTC)

Seller Dealer Buyer
• Bid – ask spread
• Settlement (T+0 or T+1 for government bonds ; T+2 or T+3 for corporate bonds)

Tender offer
Institutional / Qualified investors Issuer Investors
• Repurchase

3. Government, Government-related, supranational bonds: 3. Government, Government-related, supranational bonds:

3.1. Sovereign government bonds: 3.2. Non-sovereign government bonds:
Are issued by national governments Are issued by states, provinces, cities

Credit rating Credit rating

• Very high credit ratings for Domestic bonds • Typically high credit rating
• Lower credit ratings for Foreign or Eurobonds

Characteristic Purpose
• Most Active and most Informative • Funding public projects
• On-the-run

Coupon structure Source of payments

• Fixed-rate bonds • Tax
• Floating-rate bonds • Revenues from specific project
• Inflation-indexed bonds
3. Government, Government-related, supranational bonds: 3. Government, Government-related, supranational bonds:
3.3. Quasi-government bonds: 3.4. Supranational bonds:
Are issued by entities created by national governments for specific purposes Are issued by supranational (multilateral) agencies (E.g., World Bank, IMF)

Credit rating Credit rating

• Typically high credit rating • Typically high credit rating

Purpose Purpose
• Financing small businesses • Funding development projects (World Bank)
• Providing mortgage financing • Stabilizing world’s monetary system (IMF)
• Other Gov purposes

Source of payments Source of payments

• Cash flows from financing projects • Cash flows from financing projects

Homework:
1. The distinction between investment-grade debt and non-investment-grade debt is best described by differences in:
A. tax status.

B. credit quality.
C. maturity dates.

2. Which of the following describes privately placed bonds?

Fixed-Income : Lecture 2 (cont.)
A. They are non-underwritten and unregistered.
Corporate Debt and Funding Alternatives
B. They usually have active secondary markets.
C. They are less customized than publicly offered bonds.
• Reference : Textbook, Reading 40

3. Which type of sovereign bond has the lowest interest rate risk for an investor?
A. Floaters
B. Coupon bonds
C. Discount bonds
 1. Types of debt issued by corporations:
Learning 1.1. Commercial Paper:
Objectives Debt feature & Type of issuer
Large creditworthy corporations
1. Types of debt issued by corporations
Debt maturity
2. Short-term funding alternatives available to banks
< 1 year
3. Repurchase agreements (repos)

Purpose
Fund working capital and a temporary source of funds prior to issuing
longer-term debt

Sources of repayment
Company operation ; Re-issue ; bank line of credit

Coupon structure
Pure discount or Add-on yield

1. Types of debt issued by corporations: 1. Types of debt issued by corporations:

1.2. Bank Debt: 1.3. Corporate Bonds:

Lender(s) Borrower Debt feature & Type of issuer

• Bonds: Various types
• Medium-term notes : Most issuers and buyers are financial corporations
Bilateral loan
Debt maturity

5 year 12 year

Short term Intermediate term Long term

Coupon structure
Syndicated loan
• Bonds: fixed and floating rate
• Medium-term notes : fixed and floating rate, longer term MTNs are fixed rate

Principal repayment structure

Sinking fund provisions; Serial bond issue; Term maturity structure
1. Types of debt issued by corporations: 2. Short-term funding alternatives available to banks:

1.3. Corporate Bonds:

Customer deposits (retail) Negotiable Certificates
Principal repayment structure of deposit (CDs)
Money from retail customers Large-denomination CDs
who open checking, that can be sold to other
savings, non-negotiable CDs investors
Term maturity structure Year 1 2 3 4 5
Maturity T
Single maturity date, principal repaid in Principal
100%
lump sum repayment

Sinking Fund Provision Year 1 2 3 4 5

Payment T ≤ 1 year
Central bank funds Interbank funds
Single maturity date, certain portion of Principal
15% 15% 15% 15% 40%
principal repaid each year repayment
Borrowing from other Borrowing from other
banks that have banks without involving
Serial bond issue Year 1 2 3 4 5 excess reserves at the the central bank
Payment T1 T2 T3 T4 T5 central bank
Several maturity dates, portions of Principal
15% 15% 15% 15% 40%
issue redeemed periodically repayment

3. Repurchase agreements (repos): 3. Repurchase agreements (repos):

A short-term agreement to sell securities and buy back later at a higher price Factors affecting Repo rate and Repo margin
!"#
𝐵𝑢𝑦𝑖𝑛𝑔 𝑏𝑎𝑐𝑘 𝑣𝑎𝑙𝑢𝑒 $
Selling value < Buying back value è 𝑅𝑒𝑝𝑜 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = −1 Factor Repo rate Repo margin
𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒
Repo term (Longer) Higher Higher
𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒 Credit quality of collateral (Higher) Lower Lower
Selling value < Market value è 𝑅𝑒𝑝𝑜 𝑚𝑎𝑟𝑔𝑖𝑛 ℎ𝑎𝑖𝑟𝑐𝑢𝑡 = −1 è Securities act as collateral
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 Delivery of collateral (Delivered) Lower N/A
Alternative interest rates (Higher) Higher N/A
Credit quality of borrower (Higher) N/A Lower
Supply and demand of collateral (Higher demand) N/A Lower
Example: A firm that enters into a repo agreement to sell a 4%, 12-year bond with a par value of $1 million and a market
value of $970,000 for $940,000 and to repurchase it 90 days later (the repo date) for $947,050
Reverse Repo

Borrower Lender

Repo Reverse Repo

Homework:
1. A repurchase agreement is most comparable to a(n):
A. interbank deposit

B. collateralized loan
C. negotiable certificate of deposit
2. A characteristic of negotiable certificates of deposit is:
A. they are mostly available in small denominations
Fixed-Income : Lecture 3
B. they can be sold in the open market prior to maturity
Bond Valuation and Yield to Maturity
C. a penalty is imposed if the depositor withdraws funds prior to maturity
3. For the issuer, a sinking fund arrangement is most similar to a:
• Reference : Textbook, Reading 41
A. term maturity structure

B. serial maturity structure

C. bondholder put provision

1. Calculate bond’s price give market discount rate:

Learning 1.1. Calculate the Value of an Annual Coupon Bond
Objectives Yield-to-maturity (YTM) :
Annualized rate of return by holding the bond until maturity and reinvesting all
coupon payments at the same rate è Market discount rate

1. Calculate bond’s price give market discount rate Example: Consider a newly issued 10-year, $1,000 par value, 8% coupon, annual-pay bond. Finding value of
bond if YTM = 8% , YTM = 6% , and YTM = 10%
2. Relationships among bond’s price, market discount
rate, coupon rate, and maturity BA Calculator: N = 10 ; PMT = 80 ; FV = 1,000
Year 0 1 2 3 … 10

• YTM = 8% è I/Y = 8 è PV = … Coupon period 1 2 3 10

0
• YTM = 6% è I/Y = 6 è PV = … Discount rate YTM YTM YTM YTM

• YTM = 10% è I/Y = 10 è PV = …

• When bond yields decrease, the present value of a bond’s payments, its market value, increase
• When bond yields increase, the present value of a bond’s payments, its market value, decrease
1. Calculate bond’s price give market discount rate: 2. Relationships among bond’s price, YTM, coupon rate, and maturity:

1.2. Calculate the Value of a bond with semiannual coupon payment: 2.1. Price & YTM relationship – Convex shape:

Example: Consider a newly issued 10-year, $1,000 par value, 8% coupon, semiannual-pay bond. Example: 10-year, $1,000 par value,
Finding value of bond if YTM = 6% 8% coupon, annual-pay bond.

Year 0 1 2 3 … 10 • YTM = 8% è PV = $1,000

• YTM = 6% è PV = $1,147 è % Price change = …

Coupon period 1 2 3 4 5 6 … 20

YTM YTM YTM YTM YTM YTM YTM • YTM = 10% è PV = $877 è % Price change = …
Discount rate …
2 2 2 2 2 2 2

BA Calculator: N = 20 ; PMT = 40 ; FV = 1,000 ; I/Y = 3 è Market value (PV) = …

The percentage decrease in value when the YTM increases by a given amount is
smaller than the increase in value when the YTM decreases by the same amount

2. Relationships among bond’s price, YTM, coupon rate, and maturity: 2. Relationships among bond’s price, YTM, coupon rate, and maturity:

2.2. Price & YTM relationship – Difference in coupon rate : 2.3. Price & YTM relationship – Difference in maturity :

Example: If YTM decreases from 6% to 4%, compare % Price change of two 10-year bonds, $1,000 par Example: If YTM decreases from 6% to 4%, compare % Price change of two bonds that both have $1,000
value, coupon rate equals 7% and 9% respectively. par value, coupon rate 8%, maturity are 10 years and 20 years respectively

Bond 1: N = 10 ; PMT = 70 ; FV = 1,000 Bond 1: N = 10 ; PMT = 80 ; FV = 1,000

• YTM = 6% è I/Y = 6 è PV = … • YTM = 6% è I/Y = 6 è PV = …

• YTM = 4% è I/Y = 4 è PV = … è % Price change = … • YTM = 4% è I/Y = 4 è PV = … è % Price change = …

Bond 1: N = 10 ; PMT = 90 ; FV = 1,000 Bond 1: N = 20 ; PMT = 80 ; FV = 1,000

• YTM = 6% è I/Y = 6 è PV = … • YTM = 6% è I/Y = 6 è PV = …
• YTM = 4% è I/Y = 4 è PV = … è % Price change = … • YTM = 4% è I/Y = 4 è PV = … è % Price change = …

Other things equal, the price of a bond with a lower coupon rate is more sensitive Other things equal, the price of a bond with a longer maturity is more sensitive to
to a change in yield than is the price of a bond with a higher coupon rate a change in yield than is the price of a bond with a shorter maturity
2. Relationships among bond’s price, YTM, coupon rate, and maturity: Homework:
Practice again using the BA Calculator for all the previous examples
2.4. Price & Maturity relationship:

Constant-yield price trajectory : The convergence to par value at maturity

Learning
Objectives
1. Spot rates and calculate the price of a bond using
spot rates

Fixed-Income : Lecture 3 (cont.) 2. Full price, accrued interest, and flat price of a bond
Spot rates and Accrued interest 3. Matrix pricing

• Reference : Textbook, Reading 41

1. Spot rates and calculate the price of a bond using spot rates:

Annualized rate of return by holding the bond until maturity and reinvesting all
Yield-to-maturity (YTM) :
coupon payments at the same rate

Year 0 1 2 3 … N

Discount rate YTM YTM YTM YTM

Year 1 2 3 Total
FV $50 $50 $1,050
Spot rates : Market discount rate for a single payment to be received in the future Spot rate 3% 4% 5%
Year 0 1 2 3 … N PV
YTM
Discount rate S1 S2 S3 SN

Bond price valuing using spot rates è no-arbitrage price of bond

Example: Consider a newly issued 3-year, $1,000 par value, 5% coupon, annual-pay bond.
a. Valuing that bond using spot rates: 1-year = 3% , 2-year = 4% , and 3-year = 5%
b. Calculate YTM

2. Full price, accrued interest, and flat price of a bond: 2. Full price, accrued interest, and flat price of a bond (cont.):
Example: A $1,000 par value, 5% coupon bond makes coupon payments on 15 June and 15 December and is
Example: A $1,000 par value, 5% coupon bond makes coupon payments on 15 June and 15 December
trading with a YTM of 4%. The bond is issued on 15 June 2021, purchased and will settle on 21 August 2022
and is trading with a YTM of 4%. The bond is issued on 15 June 2021, and purchased on 15 June 2022
when there will be 4 coupons remaining until maturity. Calculate the full price of the bond using actual days.
when there will be 4 coupons remaining until maturity. Calculate the price of the bond.

15-Jun Full 15-Dec 15-Jun 15-Dec 15-Jun

Date 2022 price 2022 2023 2023 2024

15-Jun 15-Dec 15-Jun 15-Dec 15-Jun Settlement date 21-Aug

Date
2022 2022 2023 2023 2024
Last payment 15-Jun

PV (Bond price) t ? days

T ? days
N = 4 ; PMT = 25 ; FV = 1,000 ; I/Y = 2 è PV = …
PV Last payment ? ( N = 4 ; PMT = 25 ; FV = 1,000 ; I/Y = 2 )

(
Full price ? 𝐹𝑢𝑙𝑙 𝑝𝑟𝑖𝑐𝑒 = 𝑃𝑉%&'( *&+, -.( ∗ 1 + 𝑟 $
2. Full price, accrued interest, and flat price of a bond (cont.): Example:
Bond C, described in the exhibit below, is sold for settlement on 21 September 2022
• Par value $1,000
• Full price = Dirty price = Invoice price • Annual Coupon 6%
t • Coupon Payment Frequency Semiannual
• Accrued interest = ∗ PMT
T
• Interest Payment Dates 15 April and 15 October
• Flat price = Clean price = Quoted price = Full price – Accrued interest
• Maturity Date 15 October 2024

• Day-Count Method 30/360

• Actual / actual method : • Annual Yield-to-Maturity 5%

ü Using actual calendar number of days for t and T
ü Most often used with government bonds
Calculate Full price, accrued interest, and flat price:
• 30 / 360 method :
ü Assuming there 30 days each month & 360 days each year 1. If there’s no callable option on the bond
ü Most often used with corporate bonds 2. If bond can be called on 15 April 2024 at 102% of Par value

3. Matrix pricing: 3. Matrix pricing:

Purpose: estimating the required yield-to-maturity (or price) of bonds that are currently not traded or 3.2. Benchmark spreads :
infrequently traded, using YTMs of traded bonds that have close credit quality

US Treasury bond & A+ bonds of similar corporations

3.1. Linear interpolation :
Maturity 4-year 6-year 7-year
A+ bonds of similar corporations
T-bond YTM 1.48% 1.74% 2.15%

Maturity 2-year 3-year 5-year Corporate bond YTM 2.64% ? 3.55%

YTM 4.3% ? 5.2%

 Learning
Objectives
1. Calculate YTM for varying compounding

2. Yield measures for fixed-rate bonds, floating-rate notes

Fixed-Income : Lecture 4 & money market instruments
Yield Measures

• Reference : Textbook, Reading 41

1. Calculate YTM for varying compounding: 2. Yield measures for fixed-rate, floating-rate & money market instruments:

2.1. What is Yield?

Example: Consider a newly issued 5-year, $1,000 par, 7% coupon priced in the market at $1,020.78
Calculate the discount rate & Yield to maturity (YTM) if this bond pay coupon:
Bond yield : An annual-based number represents the expected returns of a specific bond
a. Annually (periodicity of the bond is 1)
b. Quarterly (periodicity of the bond is 4)
Common types of bond yields:

• Coupon rate
• Yield To Maturity (YTM)
a. N = … ; FV = … ; PMT = … ; PV = … è I/Y = … è YTM = … • Effective Annual Yield
• Current yield
a. N = … ; FV = … ; PMT = … ; PV = … è I/Y = … è YTM = … • Simple yield
• Yield to call ; Yield to worst ; Option adjusted yield

• Required margin (discount margin)

• Bond equivalent yield

2.2. Yield measures for fixed-rate bonds: 2.2. Yield measures for fixed-rate bonds:

Effective Annual Yield Current yield

𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒
.
CFA1 Review 𝑆𝑡𝑎𝑡𝑒𝑑 𝐴𝑛𝑛𝑢𝑎𝑙 𝑅𝑎𝑡𝑒
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑅𝑎𝑡𝑒 𝐸𝐴𝑅 = 1 + −1
The Time Value of Money 𝑛
Example: Calculate the current yield of a 20-year, $1,000 par value,
8% YTM, 6% coupon semiannual-pay bond.
n : compounding periods per year

.
𝑆𝑡𝑎𝑡𝑒𝑑 𝑌𝑇𝑀
BOND 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑦𝑖𝑒𝑙𝑑 = 1 + −1
𝑛

Example: Calculate Effective Annual Yield of a bond with 10% stated YTM
a. When periodicity of the bond is 2 (pay semiannually)
b. When periodicity of the bond is 4 (pay quarterly)

2.2. Yield measures for fixed-rate bonds: 2.2. Yield measures for fixed-rate bonds:

Simple yield Yield to call

𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 + 𝑠𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝑙𝑖𝑛𝑒 𝑎𝑟𝑚𝑜𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑎 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡

𝑆𝑖𝑚𝑝𝑙𝑒 𝑦𝑖𝑒𝑙𝑑 = • YTM : Yield to maturity (last date)
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒
• Yield to call : Yield to call date

𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 − 𝑠𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝑙𝑖𝑛𝑒 𝑎𝑟𝑚𝑜𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑎 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 • Yield to first call : Yield to date the bond be called first time
𝑆𝑖𝑚𝑝𝑙𝑒 𝑦𝑖𝑒𝑙𝑑 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒
• Yield to first par call : Yield to date the bond be called first time at par value

| 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 − 𝑃𝑎𝑟 𝑣𝑎𝑙𝑢𝑒 |

𝑆𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝑙𝑖𝑛𝑒 𝑎𝑟𝑚𝑜𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟 Example: A 10-year, $1,000 par, 6% coupon, semiannual-pay bond trading at 102 on
January 1, 2014. The bond is callable according to the following schedule:
• Callable at 102 on or after January 1, 2019
• Callable at 101 on or after January 1, 2021
Example: Calculate simple yield of a 3-year, 12% YTM, 8% coupon, $1,000 par value, semiannual-pay bond.
• Callable at 100 on or after January 1, 2022

Calculate YTM, yield to first call, yield to first par call.

2.2. Yield measures for fixed-rate bonds: 2.2. Yield measures for fixed-rate bonds:

Yield to worst Option adjusted yield

Definition: The lowest of yield to maturity and the various yield to call
calculations
Definition: The expected yield to maturity of a bond that is adjusted
for an embedded option, such as a call or a put

Example: A 10-year, $1,000 par, 6% coupon, semiannual-pay bond trading at 102 on

Calculation: The option-adjusted yield is calculated by adding
January 1, 2014. The bond is callable according to the following schedule:
• Callable at 102 on or after January 1, 2019 (subtracting) the value of the call (put) option to the flat price of the
bond and then finding the discount rate that equates the present
• Callable at 101 on or after January 1, 2021
• Callable at 100 on or after January 1, 2022 value of the bond’s cash flows to this adjusted price

Calculate yield to worst. PV = Flat price +/- value of the call/put option

2.3. Yield measures for floating-rate note: 2.4. Yield measures for money markets instruments:

• Money markets securities (< 1 year) yield:

• Reference rate : Market rate that determines variable part of coupon rate Can be stated as a discount yield (Selling value < Face value, E.g. US. T-bills),
or stated as add-on yield (Face value < Maturity value, E.g. LIBOR, CD),
• Quoted margin : Constant part of coupon rate and predetermined and can be based on 360-day or 365-day basis

• Coupon rate = Reference rate + quoted margin • Bond equivalent yield: money market yield stated on a 365-day add-on yield basis
è Compare the returns of different securities with different payment frequencies
• Required margin (discount margin) : Annualized required rate of return
(discount rate) used to return the FRN to its par value

365 𝐹𝑉 − 𝑃𝑉
𝐵𝑜𝑛𝑑 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 = ∗
Example: A $100,000 floating rate note is based on a 180-day MRR with a quoted margin of 120 𝐷𝑎𝑦𝑠 𝑃𝑉
basis points. On a reset date with 5 years remaining to maturity, the 180-day MRR is quoted as
3.0% (annualized) and the required rate of return (based on the issuer’s current credit rating) is
4.5% (annualized). What is the market value of the floating rate note? 365
𝐵𝑜𝑛𝑑 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 = ∗ 𝐴𝑑𝑑 𝑜𝑛 𝑦𝑖𝑒𝑙𝑑 𝑏𝑎𝑠𝑒𝑑 𝑜𝑛 360 − 𝑑𝑎𝑦 𝑦𝑒𝑎𝑟
360
2.4. Yield measures for money markets instruments (cont.):

365 𝐹𝑉 − 𝑃𝑉 365
𝐵𝑜𝑛𝑑 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 = ∗ = ∗ 𝐴𝑑𝑑 𝑜𝑛 𝑦𝑖𝑒𝑙𝑑 𝑏𝑎𝑠𝑒𝑑 𝑜𝑛 360𝑑𝑎𝑦 𝑦𝑒𝑎𝑟
𝐷𝑎𝑦𝑠 𝑃𝑉 360

Example 1: A $1,000 90-day T-bill is priced with an annualized discount of 1.2%. Calculate its market price and
its annualized add-on yield based on a 365-day year (bond equivalent yield)
Fixed-Income : Lecture 5
Yield Curves & Yield Spreads
Example 2: A $1 million negotiable CD with 120 days to maturity is quoted with an add-on yield of 1.4%
based on a 365-day year. Calculate the payment at maturity for this CD and its bond equivalent yield.
• Reference : Textbook, Reading 41

Example 3: A bank deposit for 100 days is quoted with an add-on yield of 1.5% based on a 360-day year.
Calculate the bond equivalent yield.

1. Yield curve on coupon bonds, spot curve, par curve, and forward curve:
Learning
Objectives • Term structure of interest rates : Yields at different maturities (terms) for like securities

• Yield curve on coupon bonds : Curve of YTMs for same coupon rate bonds at various maturities.
1. Compare yield curve on coupon bonds, spot curve, par
curve, and forward curve • Spot rate yield curve (zero curve) : Curve of yields (discount rates) for single payments to be
made in the future (normal, inverted, flat yield curve)
2. Forward rates
• Par bond yield curve (par curve) : Curve of coupon rates that hypothetical bond at each maturity
3. Yield spreads would need to have to be priced at par, constructed from the spot curve

𝑃𝑀𝑇 𝑃𝑀𝑇 𝑃𝑀𝑇 + 100

+ 0
+ !
= 100 ⟹ 𝑃𝑀𝑇(%)
1 + 𝑆/ 1 + 𝑆0 1 + 𝑆!

Example : With spot rates of for 1, 2, and 3 year are 1%, 2%, and 3% respectively. Calculate coupon
rate of a 1-year, 2-year, and 3-year annual par bonds. Draw par bond yield curve.
2. Forward rates: 2.2. Forward rates and spot rates relationship:
2.1. What is Forward rate?
Borrowing for 3 years at the 3-year spot rate, or borrowing for 1-year periods
in 3 successive years, should have the same cost
A borrowing/lending rate for a loan to be made at some future date

Loan period
Loan period
Notation:
Now 1 2 3 4 5 6
• 1y1y : Rate for a 1-year loan to be made one year from now Now 1 2 3 4 Now 1 2 3 4
Same cost
𝑆! 𝑆/ 1𝑦1𝑦 2𝑦1𝑦
Now 1 2 3 4 5 6
• 2y1y : Rate for a 1-year loan to be made two years from now

• 3y2y : Rate for a 2-year loan to be made three years from now Now 1 2 3 4 5 6 1 + 𝑆! !
= 1 + 𝑆/ 1 + 1𝑦1𝑦 1 + 2𝑦1𝑦

Example: If the current 1-year spot rate is 2%, the 1-year forward rate one year from today (1y1y) is
Forward yield curve : Curve of forward rates of 1-year loan for each future year
3%, and the 1-year forward rate two years from today (2y1y) is 4%, what is the 3-year spot rate?

2.2. Forward rates and spot rates relationship (cont.): 2.3. Valuing a bond using forward rates:

Example: The current 1-year rate, S1, is 4%, the 1-year forward rate for lending from time = 1
Example: The current 1-year spot rate is 4.5%, 2-year spot rate is 5.3%, and 3-year spot rate is
to time = 2 is 1y1y = 5%, and the 1-year forward rate for lending from time = 2 to time = 3 is
5.7%. Calculate the 1-year forward rate: 2y1y = 6%. Value a 3-year annual-pay bond with a 5% coupon and a par value of $1,000.
1. One year from now
2. Two years from now

Now 1 2 3 4
S 3 = 5.7%
? ? ?
S 2 = 5.3%

0 1 2 3

50 50 1050
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = + +
S 1 = 4.5% 1y1y = ? 2y1y = ? 1 + 𝑆/ 1 + 𝑆/ 1 + 1𝑦1𝑦 1 + 𝑆/ 1 + 1𝑦1𝑦 1 + 2𝑦1𝑦
3. Yield spreads: 3. Yield spreads (cont.):

Difference between the yields of two different bonds, quoted in basis points • Z-spread (Zero volatility spread) : Yield spread added to the benchmark spot rates, produces a value
equal to the market price of the bond

• Benchmark spread : Yield spread relative to a benchmark bond

𝑃𝑀𝑇1 2. 3 𝑃𝑀𝑇1 2. 3 𝑃𝑀𝑇1 2. 3 + 𝐹𝑉1 2. 3
+ 0
+⋯+ 8
= 𝑃𝑉1 2. 3
1 + 𝑆/1 -. 45, &67 + 𝑍𝑆 1 + 𝑆01 -. 45, &67 + 𝑍𝑆 1 + 𝑆81 -. 45, &67 + 𝑍𝑆
Example: Calculate benchmark spread of a 5-year corporate bond has a yield of 6.25% and its
benchmark, the 5-year Treasury note, has a yield of 3.5%.

Example: The 1-, 2-, and 3-year spot rates on Treasuries are 4.9%, 7.6%, and 10.8%, respectively.
Consider a 3-year, 8% annual coupon corporate bond trading at 89.5
• G-spread : Yield spread relative to government bond (benchmark bond is government bond) Compute the Z-spread of the corporate bond.

• I-spread : Yield spread relative to interpolated interest swap rate (fixed rate in the swap) and same tenor
• Option-adjusted spread (OAS) = Z-spread – call option value + put option value

Homework:
Calculate implied forward rates 2y3y for a loan, given spot rates of:
• 1-year = 3%

• 2-year = 4%
• 3-year = 5%
• 4-year = 7%
• 5-year = 8%
Fixed-Income : Lecture 6
Structure of Mortgage-backed securities

• Reference : Textbook, Reading 42

 Learning
Objectives
1. Definition & benefits of securitization

2. Parties involved in the process of securitization

3. Typical structures of securitization

4. Residential mortgage loans

5. Residential mortgage-backed securities

1. Definition & benefits of securitization: 1. Definition & benefits of securitization (cont.):

Definition : Financial assets (e.g., mortgages, accounts receivable, or automobile loans) are purchased
by an entity that then issues securities supported by the cash flows from those financial assets Securitization benefits

Asset flow
Bank A
Cash flow Customers
Investors • Reduces intermediation costs
Tradition Securitization
Payments • Increases liquidity of bank’s assets
Mortgage MBS
• Banks can lend more
Bank A Bank A
Investors Investors
Customers Customers
Bank A Entity B • Investor’s legal claim to assets is stronger

Mortgage Mortgage MBS Mortgage • Investors can invest in securities match their preference
Deposit,
Bank debt securities, • Provides diversification and risk reduction
Equity Asset flow
Bank A Bank A Entity B

Mortgage Cash flow

Payments
2. Parties involved in the process of securitization: 3. Typical structures of securitization:
Other parties:
• Independent accountants
3.1. Credit tranching : Credit risk is the risk of loss resulting from the issuer failing to make
Asset flow full and timely payments of interest and/or repayments of principal
Bank A • Lawyers / Attorneys
Cash flow Investors
Customers • Underwriters
Payments • Rating agencies
• Trustee Total = $410 million
Mortgage MBS • Guarantors
- + -
S e n i o r Tr a n c h e A $200 million
Bank A Entity B

Mortgage

Loss absorbed

Credit rating
$100 million

Credit risk
S e n i o r Tr a n c h e B

Yield
• Seller / depositor • Special purpose entity / vehicle (SPE / SPV)
• Servicer (not always) • Issuer / trust
S u b o r d i n a t e d Tr a n c h e A $80 million

• Mortgage-backed securities (MBS) : The loans are mortgages

• Asset-backed securities (ABS) : The loans are not only mortgages, but also other kinds of S u b o r d i n a t e d Tr a n c h e B $30 million
loan (automobile, credit card, student, corporate, structured financial products, … ) + - +

3. Typical structures of securitization (cont.): 4. Residential mortgage loans:

3.2. Time tranching : Prepayment risk is the uncertainty that the cash flows will be different from
Definition : A loan for which the collateral that underlies the loan is residential real estate
the scheduled cash flows as set forth in the loan agreement because of the
borrowers’ ability to alter payments

Loan-to-value ratio
Total = $410 million
Percentage of the value of the collateral that is loaned to the borrower
+ - Bank A
1 s t Tr a n c h e $200 million Customers

𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑙𝑜𝑎𝑛 1 − 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑟 9 𝑠 𝑒𝑞𝑢𝑖𝑡𝑦

Residential 𝐿𝑇𝑉 = =
Mortgage 𝑃𝑟𝑜𝑝𝑒𝑟𝑡𝑦 𝑣𝑎𝑙𝑢𝑒 𝑃𝑟𝑜𝑝𝑒𝑟𝑡𝑦 𝑣𝑎𝑙𝑢𝑒
Prepayment

2 n d Tr a n c h e $100 million
repayment

Credit risk
Principal

risk

Bank A Example: Property value $200,000 , customer have $50,000 . Calculate

Loan to value ratio.
3 rd Tr a n c h e $80 million

• Prime loans : Mortgages made to borrowers with good credit

4 t h Tr a n c h e $30 million • Subprime loans : Mortgages made to borrowers with lower credit quality
- +
4. Residential mortgage loans (cont.): 4. Residential mortgage loans (cont.):

Maturity
Maturity varies from country to country, ranging from 15 to 100 years

Amortization of Principal

Bank A Bank A
Customers Customers • Fully amortizing : Equal payments, include both interest and a part of principal
Interest Rate

Residential
• Fixed rate : Unchanged over the life of the mortgage
Residential
Mortgage
• Partially amortizing : Payments include some repayment of principal, and unamortized
Mortgage
• Adjustable / Variable rate : Can change based on reference rate or index amount to be paid at the end of the loan period

Bank A • Hybrid : Initial fixed for some period, then adjusted Bank A
• Interest-only mortgage : Periodic payments include interest only, all of principal to be
• Convertible : Initial fixed or adjustable, then can be changed at the option of borrower, paid at the end of the loan period (balloon payment)
to adjustable or fixed

4. Residential mortgage loans (cont.): 5. Residential mortgage-backed securities (RMBS):

Mortgage 1 Investor 1
Prepayment Provisions
Investor 2
Mortgage 2 Securitized
• Prepayment : A partial or full repayment of principal in excess of the scheduled Pool RMBS
principal repayments …
…
Bank A
Customers • Prepayment penalty : Additional payment that must be made if principal is prepaid Government
Mortgage N related Orgs Agency RMBS Investor N
Conforming loans
Residential (Mortgage pass-
(Meet standards) through securities)
Mortgage
Foreclosure Private
companies
Bank A
Nonconforming loans Nonagency RMBS
• Nonrecourse loans: Lender has no claim against the assets of the borrower except for
the collateral property itself

• Recourse loans : Lender has a claim against the assets of the borrower for the The amount and timing of
shortfall between loan outstanding principal and sale value of the property
Cash flows collected from the Cash flows paid to investors in
collateral pool of mortgages the pass-through securities

The differences due to servicing and guaranteeing fees

5. Residential mortgage-backed securities (RMBS) (cont.): 5. Residential mortgage-backed securities (RMBS) (cont.):

Mortgage 1 Investor 1 Mortgage 1

Investor 2
Mortgage 2 Securitized Mortgage 2
Pool RMBS Pool
…
… …

Mortgage N Investor N Mortgage N

WAC (WAM) = %P 1 × X 1 + %P 2 × X 2 +…+ %P n × Xn

• Weighted average coupon (WAC) rate : Where:

Mortgage rate on
Servicing and The pass- Weighting the mortgage rate of each mortgage • %P i is the weights of each mortgage value
the underlying pool guaranteeing fees • X i represents for:
through rate
of mortgages • Weighted average maturity (WAM) : Weighting ü Coupon rate for mortgage i when
the remaining number of months to maturity calculating WAC.
of each mortgage in the pool ü Remaining number of months for
mortgage i when calculating WAM.

5. Residential mortgage-backed securities (RMBS) (cont.): Homework:

Watch the movie “The Big Short”
WAC (WAM) = %P 1 × X 1 + %P 2 × X 2 +…+ %P n × Xn

Where:
• %P i is the weights of each mortgage value
• X i represents for:
ü Coupon rate for mortgage i when calculating WAC.
ü Remaining number of months for mortgage i when calculating WAM.

Example: Calculate WAC and WAM of below Mortgage pool.

 Learning
Objectives
Fixed-Income : Lecture 7 1. Prepayment risk & CMO structures

Prepayment Risk and 2. Nonagency RMBS & Commercial MBS

Non-mortgage-backed ABS 3. Non-mortgage ABS

4. CDO & Covered bonds

• Reference : Textbook, Reading 42

1. Prepayment risk & CMO structures:

1.2. Collateralized Mortgage Obligations (CMO) :
1.1. Prepayment risk :

Mortgage loans used as collateral have no prepayment penalty è prepayment risk

Mortgage 1

• Extension risk : Prepayments will be slower than expected (When interest rate rise)
Mortgage 2 Securitized Securitized
Collateral
• Contraction risk : Prepayments will be faster than expected (When interest rate decline) RMBS CMOs
pool
…
CFs allocated
𝑃𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑓𝑜𝑟 𝑚𝑜𝑛𝑡ℎ
𝑆𝑖𝑛𝑔𝑙𝑒 𝑚𝑜𝑛𝑡ℎ𝑙𝑦 𝑚𝑜𝑟𝑡𝑎𝑙𝑖𝑡𝑦 (𝑆𝑀𝑀) = Mortgage N
𝑆𝑐ℎ𝑒𝑑𝑢𝑙𝑒𝑑 𝐸𝑛𝑑. 𝑚𝑜𝑟𝑡𝑔𝑎𝑔𝑒 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝑓𝑜𝑟 𝑚𝑜𝑛𝑡ℎ Tranche 1 Tranche N
Tranche 2 …

𝐶𝑜𝑛𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑝𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 𝐶𝑃𝑅 = 𝐴𝑛𝑛𝑢𝑎𝑙𝑖𝑧𝑒𝑑 𝑆𝑀𝑀

Investor 1
Investor 2 Investor N
Public Securities Association Prepayment Benchmark (PSA) is the benchmark for CPR …
• 100 PSA : CPR same as standard benchmark
• > 100 PSA : CPR faster than standard benchmark Redistributed
• < 100 PSA : CPR slower than standard benchmark Prepayment Risk
1.3. Sequential Pay CMO : 1.4. Planned Amortization Class (PAC) CMO :

CMOs CMOs

CFs allocated CFs allocated

Tranche 1 Tranche 2 … Tranche N PAC tranches Support tranches

Coupon rates // The same // Principal payments As scheduled Absorb prepayments (if any)

Principal payments Waterfall

• Initial PAC collar: Upper and lower bounds on prepayment that support
Principal of Tranche 1 must be fully repaid tranches can provide/absorb
before Tranche 2 begins to be paid
• Broken PAC : Prepayment is outside of these bounds

2. Nonagency RMBS & Commercial MBS:

2.2. Commercial MBS:
2.1. Nonagency RMBS:

Definition: MBS not issued by government-related organizations Definition: CMBS are backed by income-producing real estate mortgage

Examples: Shopping centers, office buildings, hotel, warehouses, …

• Risk : Prepayment risk & Credit risk

𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒 (𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑐𝑜𝑚𝑒 𝑡𝑎𝑥𝑒𝑠)
• Structure : Credit tranching (senior / subordinated tranches) 𝐷𝑒𝑏𝑡 𝑠𝑒𝑟𝑣𝑖𝑐𝑒 𝑐𝑜𝑣𝑒𝑟𝑎𝑔𝑒 (𝐷𝑆𝐶) =
𝐷𝑒𝑏𝑡 𝑠𝑒𝑟𝑣𝑖𝑐𝑒 (𝐷𝑒𝑏𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠)

• Shifting interest mechanism : Suspend payments to subordinated

securities if credit quality of senior securities decrease 𝐿𝑜𝑎𝑛 𝑎𝑚𝑜𝑢𝑛𝑡
𝐿𝑜𝑎𝑛 𝑡𝑜 𝑣𝑎𝑙𝑢𝑒 (𝐿𝑇𝑉) =
𝑃𝑟𝑜𝑝𝑒𝑟𝑡𝑦 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒
2.2. Commercial MBS (cont.) : 2.2. Commercial MBS (cont.) :

Prepayment Protection (Call protection)

Ballon risk protection
Mortgage 1 Investor 1

Investor 2
Mortgage 2 Collateral Securitized The borrower fails to make The lender may extend the loan over a
CMBS
pool … the balloon payment period known as the “workout period”
…

Original loan’s term Workout period

Mortgage N Investor N
Loan level CMBS level
higher interest rate

• Prepayment lockout • Time Tranching

(Principal waterfall repayment)
• Defeasance

• Prepayment penalty points

• Yield maintenance charges

3. Non-mortgage ABS: 3. Non-mortgage ABS (cont.):

Small business loans Credit card loans Home equity loans

Small business loans
Investor 1

Credit card loans Investor 2

Securitized Non-mortgage
Pool
ABS
…
…

Home equity loans Investor N

…
Automobile loans

Accounts receivable loans Automobile loans Other Non-mortgage

loans
4. CDO & Covered bonds: 4. CDO & Covered bonds:

4.1. Collateralized Debt Obligations (CDO): 4.2. Covered bonds:

ABS Senior Investors A type of financial organization bond that backed by that
tranches organization’s pool of collateral (no SPE created, no securitizing)
RMBS Collateral Securitized
CDOs Mezzanine Investors
pool tranches
CMBS
Residual Mortgage 1 Investor 1
CDS Investors
(Equity)
(Credit Default Swaps) tranches Investor 2
Loan 2 Collateral Covered
pool bonds …
…

Collateral manager buy and sell securities in collateral pool to generate cash to make the Investor N
Mortgage / Loan N
promised payments to investors (instead of rely on interest payments from the collateral pool)

Homework:
1. If a mortgage borrower makes prepayments without penalty to take advantage of falling interest rates, the
lender will most likely experience:
A. extension risk.
B. contraction risk.
C. yield maintenance. Fixed-Income : Lecture 8
2. In the context of mortgage-backed securities, a conditional prepayment rate (CPR) of 8% means that Sources of Returns, Duration
approximately 8% of the outstanding mortgage pool balance at the beginning of the year is expected to be
prepaid:
A. in the current month.
B. by the end of the year. • Reference : Textbook, Reading 43

C. over the life of the mortgages.

3. Which statement about covered bonds is least accurate?
A. Covered bonds provide investors with dual recourse, to the cover pool and also to the issuer.
B. Covered bonds usually carry higher credit risks and offer higher yields than otherwise similar ABS.
C. Covered bonds have a cover pool of mortgages and loans.
 1. Sources of return from a fixed-rate bond:
Learning 1.1. Hold to maturity :
Objectives Example: 3-year bond, $1,000 par, 6% annual coupon rate, 7% YTM, hold to maturity

1. Sources of return from a fixed-rate bond

Year 0 1 2 3 Total
2. Macaulay, modified, effective durations
Buy Sell

PV =

Principal payment =

Coupon payment =

Coupon reinvestment income =

Holding period rate of return =

1.2. Sale prior to maturity : 1.3. Risk comparison :

Market price risk: Uncertainty about price due to uncertainty about market YTM
Example: 3-year bond, $1,000 par, 6% annual coupon rate, 7% YTM, Sell $995 at the end of year 2
Reinvestment risk: Uncertainty about future reinvestment rate of coupon payments

Year 0 1 2 3 Total

Buy Sell ($995) Year 0 1 2 3

Investment horizon

Purchased value = Buy Sell è Market price risk = 0

Carrying value (Principal) = Buy Sell è Reinvestment risk = 0

Capital gain/loss = + Market price risk -

Coupon payment = - Reinvestment risk +

Coupon reinvestment income =

Short investment horizon: Market price risk > Reinvestment risk

Holding period rate of return =

Long investment horizon: Market price risk < Reinvestment risk
2. Macaulay, modified, effective durations:
2.2. Modified duration :
2.1. Macaulay duration :
Year 0 1 2 3
Definition: Weighted average of number of years until each of the bond’s promised cash flows is to be paid,
where the weights are the present values of each cash flow as a percentage of the bond’s full value Coupon 4%, YTM 5%, Par $1,000

Macaulay duration =
Year 0 1 2 3
𝑴𝒂𝒄𝒂𝒖𝒍𝒂𝒚 𝑫𝒖𝒓𝒂𝒕𝒊𝒐𝒏
Coupon 4%, YTM 5%, Par $1,000 =
𝟏 + 𝒀𝑻𝑴

CF = PV (YTM 5%) =

PV =
If YTM changes to 6% If YTM changes to 4%
Weight =
PV (YTM 6%) = PV (YTM 4%) =
Macaulay duration =
%∆ 𝒊𝒏 𝑷𝑽 = %∆ 𝒊𝒏 𝑷𝑽 =

2.2. Modified duration (cont.) : 2.2. Modified duration (cont.) :

𝑴𝒂𝒄𝒂𝒖𝒍𝒂𝒚 𝑫𝒖𝒓𝒂𝒕𝒊𝒐𝒏
𝑴𝒐𝒅𝒊𝒇𝒊𝒆𝒅 𝑫𝒖𝒓𝒂𝒕𝒊𝒐𝒏 = Year 0 1 2 3
𝟏 + 𝒀𝑻𝑴
Coupon 4%, YTM 5%, Par $1,000

Definition: Approximate percentage change in a bond’s price for a 1% change in yield to maturity (YTM)
PV (YTM 5%) = 𝑽 𝟎 =

𝐴𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒 %∆ 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 = −𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 ∗ ∆𝑌𝑇𝑀

PV (YTM 6%) = 𝑽 ? =

PV (YTM 4%) = 𝑽 @ =
Semi-annual coupon bond

𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 :;< = 𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 :;< = 𝑽@ − 𝑽?

𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 :;< = = 𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 𝑨𝒑𝒑𝒓𝒐𝒙𝒊𝒎𝒂𝒕𝒆 𝑴𝒐𝒅𝒊𝒇𝒊𝒆𝒅 𝑫𝒖𝒓𝒂𝒕𝒊𝒐𝒏 = =
𝑌𝑇𝑀 2 𝟐 ∗ 𝑽 𝟎 ∗ ∆𝒀𝑻𝑴
1+
2
2.3. Effective duration : Homework:
1. A “buy-and-hold” investor purchases a fixed-rate bond at a discount and holds the
Definition: Approximate percentage change in mortgage-back securities price or security until it matures. Which of the following sources of return is least likely to
embedded options bond price for a 1% change in benchmark yield curve
contribute to the investor’s total return over the investment horizon, assuming all
payments are made as scheduled?
𝑽@ − 𝑽?
𝑬𝒇𝒇𝒆𝒄𝒕𝒊𝒗𝒆 𝑫𝒖𝒓𝒂𝒕𝒊𝒐𝒏 =
𝟐 ∗ 𝑽 𝟎 ∗ ∆𝒄𝒖𝒓𝒗𝒆
A. Capital gain
B. Principal payment
C. Reinvestment of coupon payments
YTM YTM
2. An investor buys a three-year bond with a 5% coupon rate paid annually. The
5.5%
⇒ ∆𝒄𝒖𝒓𝒗𝒆
bond, with a yield-to-maturity of 3%, is purchased at a price of 105.657223 per 100 of
par value. Assuming a 5-basis point change in yield-to-maturity, the bond’s
5% ⇒ ∆𝒀𝑻𝑴
approximate modified duration is closest to:
4.5% A. 2.78
B. 2.86
3-year Maturity Maturity
C. 5.56

Learning
Objectives
Fixed-Income : Lecture 9 1. Key rate duration

Interest rate risk and money duration 2. How maturity, coupon, and yield level affect bond’s
interest rate risk

3. Portfolio duration

4. Money duration & Price value of basis point (PVBP)

• Reference : Textbook, Reading 43
1. Key rate duration: 2. How maturity, coupon, and yield level affect bond’s interest rate risk:

Definition: Approximate percentage change in bond’s price for a 1% change in spot rate on
Market price risk = Interest rate risk = Duration risk = More/Less sensitivity of bond’s price to yield changes
benchmark yield curve at a specific maturity, holding other spot rates constant

è Each maturity will have a key rate duration

All other things equal

𝐏𝐚𝐫𝐚𝐥𝐥𝐞𝐥 𝐬𝐡𝐢𝐟𝐭 𝐍𝐨𝐧𝐩𝐚𝐫𝐚𝐥𝐥𝐞𝐥 𝐬𝐡𝐢𝐟𝐭

YTM YTM Maturity increase Sensitivity increase Interest rate risk increase

Coupon rate increase Sensitivity decrease Interest rate risk decrease

YTM increase Sensitivity decrease Interest rate risk decrease

Maturity Maturity

3. Portfolio duration : 4. Money duration & Price Value of Basis Point (PVBP) :

4.1. Money duration :

Money duration = Annual modified duration * Full price of bond position

Year 0 1 2 3 … 29 30 Example 1: Calculate the money duration on a coupon date of a $2 million par value bond that has a modified
duration of 7.42 and a full price of 101.31, expressed for the whole bond and per $100 of face value
Bond X 9.8 mil. 10 mil.
100 mil.
Bond Y 9.8 mil.

∆𝑭𝒖𝒍𝒍 𝒑𝒓𝒊𝒄𝒆 ≈ −𝑴𝒐𝒏𝒆𝒚 𝒅𝒖𝒓𝒂𝒕𝒊𝒐𝒏 ∗ ∆𝒀𝒊𝒆𝒍𝒅

1 st approach (Total Cash flow) : Cash flow yield è Portfolio duration

Example 2: What will be the impact on the value of the bond of a 25 basis points increase in its YTM?

2 nd approach (Weighted individuals) : Portfolio duration = W 1D 1 + W 2D 2 + W ND N

4. Money duration & Price Value of Basis Point (PVBP) : Homework:
1. Which of the following is most appropriate for measuring a bond’s sensitivity to shaping risk?
4.2. Price value of a basis point (PVBP) :
A. Key rate duration

B. Effective duration

Definition: The change in full price of a bond when the YTM changes by 1bp (0.01%) C. Modified duration

𝑽@ − 𝑽? 2. A bond with exactly nine years remaining until maturity offers a 3% coupon rate with annual coupons. The bond, with a
𝑷𝑽𝑩𝑷 =
𝟐 yield-to-maturity of 5%, is priced at 85.784357 per 100 of par value. The estimated price value of a basis point for the
bond is closest to:
A. 0.0086.

Example: A newly issued, 20-year, 6% annual-pay straight bond is priced at 101.39. Calculate the B. 0.0648.
price value of a basis point for this bond assuming it has a par value of $1 million.
C. 0.1295.

Learning
Objectives
Fixed-Income : Lecture 9 (cont.) 1. Approximate convexity & effective convexity

Convexity and Yield Volatility 2. Bond price sensitivity to yield, given duration &
convexity

3. Bond holding period return, duration & investment

horizon relationships

• Reference : Textbook, Reading 43 4. Duration & convexity used to estimate price effect of
YTM changes, due to changes in credit spread and
liquidity

5. Empirical duration & analytical duration

1. Approximate convexity & effective convexity: 1. Approximate convexity & effective convexity (cont.) :

Year 0 1 2 3

Coupon 4%, YTM 5%, Par $1,000

PV (YTM 5%) = 𝑽 𝟎 =

PV (YTM 6%) = 𝑽 ? =

PV (YTM 4%) = 𝑽 @ =

𝑽@ − 𝑽?
𝑴𝒐𝒅𝒊𝒇𝒊𝒆𝒅 𝑫𝒖𝒓𝒂𝒕𝒊𝒐𝒏 = =
𝟐 ∗ 𝑽 𝟎 ∗ ∆𝒀𝑻𝑴

𝑨𝒑𝒑𝒓𝒐𝒙𝒊𝒎𝒂𝒕𝒆 %∆ 𝑷𝑽 = −𝑴𝒐𝒅𝒊𝒇𝒊𝒆𝒅 𝑫𝒖𝒓𝒂𝒕𝒊𝒐𝒏 ∗ ∆𝒀𝑻𝑴 =

𝑨𝒑𝒑𝒓𝒐𝒙𝒊𝒎𝒂𝒕𝒆 𝑷𝑽 𝒀 𝑻𝑴 𝟔% = 𝑷𝑽 𝒀 𝑻𝑴 𝟓% ∗ 𝟏 + 𝑨𝒑𝒑𝒓𝒐𝒙𝒊𝒎𝒂𝒕𝒆 %∆ 𝑷𝑽 =

1. Approximate convexity & effective convexity (cont.) : 1. Approximate convexity & effective convexity (cont.) :

Convexity:

• Measure of the curvature of the price-yield relation Convexity of callable bond Convexity of putable bond
• Adjustment to a duration-based estimate

Option-free bond Embedded-option bond

𝑽 @ + 𝑽 ? − 𝟐𝑽 𝟎 𝑽 @ + 𝑽 ? − 𝟐𝑽 𝟎
𝑨𝒑𝒑𝒓𝒐𝒙𝒊𝒎𝒂𝒕𝒆 𝒄𝒐𝒏𝒗𝒆𝒙𝒊𝒕𝒚 = 𝑨𝒑𝒑𝒓𝒐𝒙𝒊𝒎𝒂𝒕𝒆 𝒆𝒇𝒇𝒆𝒄𝒕𝒊𝒗𝒆 𝒄𝒐𝒏𝒗𝒆𝒙𝒊𝒕𝒚 = 𝟐
∆𝒀𝑻𝑴 𝟐 ∗ 𝑽 𝟎 ∆𝒄𝒖𝒓𝒗𝒆 ∗ 𝑽𝟎

Convexity increases when:

• Longer maturity
• Lower coupon rate
• Lower YTM
• Cash flows more dispersed
2. Bond price sensitivity to yield, given duration & convexity : 3. Bond holding period return, duration & investment horizon relationships :

Review: Lecture 8 – Market price & reinvestment risk comparison

𝟏 𝟐
%∆ 𝑷𝑽 𝑭𝒖 𝒍𝒍 = − 𝑨𝒏𝒏𝒖𝒂𝒍 𝑴𝒐𝒅𝒊𝒇𝒊𝒆𝒅 𝑫𝒖𝒓𝒂𝒕𝒊𝒐𝒏 ∗ ∆𝒀𝑻𝑴 + ∗ 𝑨𝒏𝒏𝒖𝒂𝒍 𝑪𝒐𝒏𝒗𝒆𝒙𝒊𝒕𝒚 ∗ ∆𝒀𝑻𝑴
𝟐
Duration gap : The difference between the Macaulay duration of a bond and the investment horizon.

Duration gap = Macaulay duration - Investment horizon

Example: Year 0 1 2 3
Investment horizon Maturity
Coupon 4%, YTM 5%, Par $1,000 Market price risk > Coupon reinvestment risk
Macaulay duration

𝑽 @ + 𝑽 ? − 𝟐𝑽 𝟎
𝑨𝒑𝒑𝒓𝒐𝒙𝒊𝒎𝒂𝒕𝒆 𝒄𝒐𝒏𝒗𝒆𝒙𝒊𝒕𝒚 = 𝟐
= Investment horizon
∆𝒀𝑻𝑴 ∗ 𝑽𝟎
Market price risk = Coupon reinvestment risk
Macaulay duration
%∆ 𝑷𝑽 𝑭𝒖 𝒍𝒍 =
Investment horizon
𝑷𝑽 𝒀 𝑻𝑴 𝟔% = 𝑷𝑽 𝒀 𝑻𝑴 𝟓% ∗ 𝟏 + %∆ 𝑷𝑽 𝑭𝒖 𝒍𝒍 = Market price risk < Coupon reinvestment risk
Macaulay duration

Learning
Objectives
Fixed-Income : Lecture 10 1. Describe credit risk and credit-related risks

Credit Risk and Bond Ratings 2. Seniority rankings of corporate debt

3. Credit ratings and notching

4. Risk in relying on credit rating agencies

• Reference : Textbook, Reading 44 5. Four Cs of traditional credit analysis

1. Describe credit risk and credit-related risks : 1. Describe credit risk and credit-related risks :
1.1. Credit risk : 1.2. Credit-related risk :

Spread risk refers to the risk of an increase in the yield spread on the bond.
Credit risk is the risk of loss resulting from a borrower’s failure to make full and timely payments of
interest and/or principal.
If a bond becomes riskier, the spread will increase, resulting in an increase
in the required yield on the bond.
Default risk Loss severity
(Default probability) (Loss given default)
A decrease in the bond market value.
This refers to the probability of a This refers to the portion of the bond’s value that an
borrower failing to meet its investor would lose if a default actually occurred.
obligations to make full and timely Loss severity = 1 – The recovery rate
Downgrade risk
payments of principal and interest Where the recovery rate is the percentage of the principal Market liquidity risk
(Credit migration risk)
under the terms of the bond amount plus unpaid interest recovered in the event of
indenture. default. This is the risk that the issuer’s This is the risk that an investor may
creditworthiness may deteriorate have to sell her investment at a
during the term of the bond, causing price lower than its market value
Expected loss is calculated as the probability of default multiplied by loss severity: rating agencies to downgrade the due to insufficient volumes
credit rating of the issue. (liquidity) in the market.
Expected loss = Default probability x Loss given default

2. Seniority rankings of corporate debt: 3. Credit ratings and notching:

3.1. Credit ratings :

Secured debt First Lien Loan – Senior Secured

Priority of claims in the event of default

Holders of secured debt have a

direct claim on certain assets
and their associated cash flows. Second Lien Loan – Secured
Issuer rating
Category of debt

(Corporate family rating)

Senior Unsecured

Unsecured debt
Holders of unsecured debt
≠
Senior Subordinated
have only a general claim on
Issue rating
the issuer’s assets and cash (Corporate credit rating)
flow. Subordinated

Junior Subordinated
3. Credit ratings and notching: 4. Risk in relying on credit rating agencies:
3.2. Notching :
Mechanism of Notching

Rating agencies adjust credit ratings for specific issues up or down relative to 1. Credit ratings can change over time (Higher credit ratings to be
more stable than lower credit ratings)
the issuer rating

Risks in relying on
For more risky issuers (lower credit ratings)

agency ratings
2. Credit ratings tend to lag the market’s pricing of credit risk
(Prices change more quickly than credit rating assigned)
The probability of default is higher, so the potential A larger
difference in loss from a lower or higher seniority ranking is notching
a bigger consideration in assessing the issue’s credit risk. adjustment 3. Rating agencies may make mistakes (not perfect)

For less risky issuers (higher credit ratings) 4. Some risks are difficult to capture in credit ratings (Litigation
risks, Environmental risks, …)

The probability of default is lower, so there is less of a A smaller

need to notch ratings to capture any potential difference notching
in loss severity. adjustment

5. Four Cs of traditional credit analysis:

Capacity Collateral
Ability of the borrower to Quality and value of
make its debt payments on assets that are pledged
time (Industry structure à against the issuer’s debt
Industry fundamentals à obligations Fixed-Income : Lecture 10 (cont.)
Company fundamentals)
Evaluating Credit Quality

4 Cs

Covenants Character • Reference : Textbook, Reading 44

Terms & conditions of Quality and integrity of

lending agreements management (strategy,
that the issuer must track record, accounting
comply with policies and tax strategies,
(Affirmative covenants, history of fraud or
Negative covenants) malfeasance, prior
treatment of bondholders)
 2. Macroeconomic, market, and other factors influence yield spreads:
Learning
Objectives Yield spread = Liquidity premium + Credit spread

Yield spreads on corporate bonds are affected by the following:

1. Financial ratios used in credit analysis
Factors that narrow yield spread Factors that widen yield spread
2. Macroeconomic, market, and other factors that
influence level and volatility of yield spreads Credit cycle improve Credit cycle deteriorate

3. Special considerations when evaluating credit of high- Broader economic conditions strengthen Broader economic conditions weaken
yield, sovereign, non-sovereign issuers and issues
Sufficient funding availability in financial Insufficient funding availability in
sector financial sector

High market demand Low market demand

Low market supply High market supply

Positive financial performance of issuer Negative financial performance of issuer

3. Evaluating credit of high-yield, sovereign, non-sovereign issuers & issues : 3. Evaluating credit of high-yield, sovereign, non-sovereign issuers & issues :
3.1. High yield issuers & issues: 3.1. High yield issuers & issues:

Companies are rated below investment grade for many reasons,

including the following:
High-yield analysis typically is more in-depth than investment-grade analysis
Highly leveraged capital structure and thus, has special considerations. This includes the following:
Greater focus on issuer liquidity and cash flow
Weak or limited operating history

Limited or negative free cash flow Detailed financial projections

Highly cyclical business Detailed understanding and analysis of the debt structure

Poor management Understanding of an issuer’s corporate structure

Risky financial policies Covenants

Lack of scale and/or competitive advantages Equity-like approach to high-yield analysis

Large off-balance-sheet liabilities

Declining industry (e.g., newspaper publishing)
3. Evaluating credit of high-yield, sovereign, non-sovereign issuers & issues : 3. Evaluating credit of high-yield, sovereign, non-sovereign issuers & issues :
3.2. Sovereign issuers & issues: 3.2. Sovereign issuers & issues:

economic profile
An assessment of willingness to service debt is particularly important for
1. Institutional effectiveness & political risks

Political &
sovereign debt, as bondholders typically have no legal recourse a national
government is unwilling to meet its debt
2. Economic structure & growth prospects
Credit analysis of sovereign bonds entails an evaluation of the government’s
ability and willingness to service its debt, by assessing the following

Political & economic profile

1. External liquidity & international investment position

Flexibility and
performance
Flexibility and performance profile

profile
2. Fiscal performance, flexibility & debt burden

3. Monetary flexibility

3. Evaluating credit of high-yield, sovereign, non-sovereign issuers & issues : 3. Evaluating credit of high-yield, sovereign, non-sovereign issuers & issues :
3.3. Non-Sovereign issuers & issues: 3.3. Non-Sovereign issuers & issues:

General obligation (GO) bonds are unsecured bonds issued with the full
faith and credit of the issuing non-sovereign government. These bonds are
supported by the taxing authority of the issuer. Revenue bonds, which are issued to finance a specific project, have a higher degree
of risk than GO bonds because they are dependent on a single source of revenue.
Economic factors to assess in evaluating the creditworthiness of GO bonds
include
Employment Analysis of revenue bonds combines analysis of the project, using techniques like
Trends in per capita income and in per capita debt those for analyzing corporate bonds, with analysis of the financing of the project.
Tax base dimensions
Demographics
Net population growth
Ability to attract new jobs
1. A money market security most likely matures in: 4. Loss severity is most accurately defined as the:
A) One year or less. A) Percentage of a bond’s value a bondholder will receive if the issuer defaults.
B) Between 1 and 10 years. B) Amount a bondholder will lose if the issuer defaults.
C) Over 10 years. C) Probability that a bond issuer will default.

2. A bond has a par value of £100 and a coupon rate of 5%. Coupon payments are made semi- 5. How does the price-yield relationship for a callable bond compared to the same relationship for
annually. The periodic interest payment is: an option- free bond? The price-yield relationship is best described as exhibiting:
A) £2.50, paid twice a year. A) She same convexity for both bond types.
B) £5.00, paid once a year. B) Negative convexity for the callable bond and positive convexity for an option-free bond
C) £5.00, paid twice a year. C) Negative convexity at low yields for the callable bond and positive convexity for the option-
free bond.

3. The external credit enhancement that has the least amount of third-party risk is a: 6. Price risk will dominate reinvestment risk when the investor's:
A) Surety bond. A) Duration gap is negative.
B) Letter of credit. B) Investment horizon is less than the bond’s tenor.
C) Cash collateral account. C) Duration gap is positive.

7. A mortgage is most attractive to a lender if the loan: 10. Which of the following is least likely an example of external credit enhancement?:
A) is convertible from fixed-rate to adjustable-rate. A) Bank guarantee.
B) has a prepayment penalty. B) Surety bond.
C) is non-recourse. C) Excess spread.

8. An asset-backed security with a senior/subordinated structure is said to have: 11. A non-callable bond with 18 years remaining maturity has an annual coupon of 7% and a
A) Time tranching. $1,000 par value. The current yield to maturity on the bond is 8%. Using a 50bp change in YTM,
B) Credit tranching. the approximate modified duration of the bond is:
C) Prepayment tranching. A) 8.24.
B) 11.89.
C) 9.63.

9. A bond has a par value of $5,000 and a coupon rate of 8.5% payable semi-annually. The bond is 12. Which of the following is the most appropriate strategy for a fixed income portfolio manager
currently trading at 112.16. What is the dollar amount of the semi-annual coupon payment?: under the anticipation of an economic expansion:
A) $238.33. A) Sell corporate bonds and purchase Treasury bonds.
B) $212.50. B) Purchase corporate bonds and sell Treasury bonds.
C) $425.00. C) Sell lower-rated corporate bonds and buy higher-rated corporate bonds.
13. Expected loss is greatest for a corporate bond with a low: 16. The price of a bond is equal to $101.76 if the term structure of interest rates is flat at 5%. The
A) recovery rate and a high probability of default. following bond prices are given for up and down shifts of the term structure of interest rates. Using
B) loss severity and a high probability of default. the following information what is the approximate percentage price change of the bond using
C) recovery rate and a low probability of default. effective duration and assuming interest rates decrease by 0.5%?
Bond price: $98.46 if term structure of interest rates is flat at 6%
Bond price: $105.56 if term structure of interest rates is flat at 4%
14. Structural subordination is most likely to be a credit rating consideration for: A) 0.0087%.
A) general obligation municipal bonds. B) 1.74%.
B) emerging market sovereign bonds. C) 0.174%.
C) high-yield corporate bonds.
17. Which of the following duration measures is most appropriate if an analyst expects a non-
parallel shift in the yield curve?
A) Effective duration.
15. An annual-pay bond is priced at 101.50. If its yield to maturity decreases 100 basis points, its B) Modified duration.
C) Key rate duration.
price will increase to 105.90. If its yield to maturity increases 100 basis points, its price will
decrease to 97.30. The bond's approximate modified convexity is closest to:
A) 4.2.
B) 0.2.
C) 19.7.

18. An investor purchases a 4-year, 6%, semiannual-pay Treasury note for $9,485. The security 21. A $1,000 par value bond has a modified duration of 5. If the market yield increases by 1% the
has a par value of $10,000. To realize a total return equal to 7.515% (its yield to maturity), all bond's price will:
payments must be reinvested at a return of: A) increase by $50.
A) more than 7.515%. B) decrease by $50.
B) less than 7.515%. C) decrease by $60.
C) 7.515%.

19. Jane Walker has set a 7% yield as the goal for the bond portion of her portfolio. To achieve this 22. Negative effective convexity will most likely be exhibited by a:
goal, she has purchased a 7%, $1,000 par value, 15-year corporate bond at a discount price of A) callable bond at low yields.
93.50. What amount of reinvestment income will she need to earn over this 15-year period to B) putable bond at high yields.
achieve a compound return of 7% on a semiannual basis? C) callable bond at high yields.
A) $459.
B) $574.
C) $624. 23. Which of the following is a limitation of the portfolio duration measure? Portfolio duration only
considers:
20. An investor who buys bonds that have a Macaulay duration less than his investment horizon: A) the market values of the bonds.
A) has a negative duration gap. B) a linear approximation of the actual price-yield function for the portfolio.
B) will benefit from decreasing interest rates. C) a nonparallel shift in the yield curve.
C) is minimizing reinvestment risk.
24. An international bond investor has gathered the following information on a 10-year, annual-pay
U.S. corporate bond: Currently trading at par value ; Annual coupon of 10% ; Estimated price if
rates increase 50 basis points is 96.99% ; Estimated price is rates decrease 50 basis points is
103.14% . The bond's modified duration is closest to:
A) 6.15.
B) 3.14.
C) 6.58.

25. Suppose the 3-year spot rate is 12.1% and the 2-year spot rate is 11.3%. Which of the following
statements concerning forward and spot rates is most accurate? The 1-year:
A) forward rate one year from today is 13.7%.
B) forward rate two years from today is 13.7%.
C) forward rate two years from today is 13.2%.