Risks associated with investing in bonds 1.

Interest-rate risk The price of a typical bond will change in the opposite direction from a change in interest rates: As interest rates rise, the price of a bond will fall; as interest rates fall, the price of a bond will rise. If an investor has to sell a bond prior to the maturity date, an increase in interest rate will mean the realisation of a capital loss (i.e. selling the bond below the purchase price). This risk is referred to as interest-rate risk or market risk. This risk is by far the major risk faced by an investor in the bond market. 2. Reinvestment income or Reinvestment risk This risk is that the interest rate at which interim cash flows can be reinvested will fall. Reinvestment risk is greater for longer holding periods, as well as for bonds with large, early cash flows, such as high-coupon bonds. Interest rate risk and reinvestment risk have offsetting effects. That is, interest-rate risk that interest rates will rise, thereby reducing a bonds price. In contrast, reinvestment risk is the risk that interest rates will fall. A strategy based on these offsetting effects is called immunisation. 3. Call risk Bonds may include a provision that allows the issuer to retire or call all or part of the issue before the maturity date. From the investors perspective, there are three disadvantages to call provisions. First, the cash flow pattern of a callable bond is not known with certainty. Second, because the issuer will call the bonds when interest rates have dropped, the investor is exposed to reinvestment risk (i.e. the investor will have to reinvest the proceeds when the bond is called at relatively lower interest rates). Finally, the capital appreciation potential of a bond will be reduced because the price of a callable bond may not rise much above the price at which the issuer will call the bond. 4. Credit risk - Default risk: The risk that the issuer of a bond will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed. Market participants gauge the default risk of an issue by looking at the default rating or credit rating assigned to a bond issue by one of the three rating companies (Standard & Poors, Moodys, and Fitch). - Spread = A premium to compensate for the risks associated with the bond issue that do not exist in a Treasury issue. Credit spread = Part of the risk premium attributable to default risk
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The price performance of a non-Treasury debt obligation and its return over some investment horizon will depend on how the credit spread of a bond issue changes. If the credit spread increases Investors say that the spread has widened the market price of the bond will decline. The risk that a bond issue will decline due to an increase in the credit spread is called credit spread risk. - An unanticipated downgrading of an issue or issuer increases the credit spread sought by the market, resulting in a decline in the price of the issue or the issuers debt obligation. This risk is referred to as downgrade risk. 5. Inflation risk Inflation risk/purchasing power risk arises because of the variation in the value of cash flows from a security due to inflation, as measured in terms of purchasing power. For example, if investors purchase a bond on which they can realise a coupon rate of 7% but the rate of inflation is 8%, the purchasing power of the cash flow actually has declined. For all but floating rate bonds, an investor is exposed to inflation risk because the interest rate the issuer promises to make is fixed for the life of the issue. To the extent that interest rates reflect the expected inflation rate, floating rate bonds have a lower level of inflation risk. 6. Exchange rate risk From the perspective of a US investor, a non-dollar denominated bond has unknown US dollar cash flows. The dollar cash flows are dependent on the exchange rate at the time the payments are received. This is referred to as exchange-rate or currency risk. 7. Liquidity risk Liquidity or marketability risk depends on the ease with which an issue can be sold at or near its value. The primary measure of liquidity is the size of the spread between the bid price and the ask price quoted by a dealer. The wider the dealer spread, the more the liquidity risk. For individual investors who plan to hold a bond until it matures and have the ability to do so, liquidity risk is unimportant. In contrast, institutional investors must market their positions to market periodically. Marking a portfolio to market, or simply marking to market, means that the portfolio manager must periodically determine the market value of each bond in the portfolio. To get prices that reflect market value, the bonds must trade with enough frequency. 8. Volatility risk The risk that a change in volatility will affect the price of a bond adversely is called volatility risk. 9. Risk risk Risk risk is defined as not knowing what the risk of a security is. In order to eliminate this risk, firms need to keep updated with all the new methodologies to analyse securities and avoid securities that are not clearly understood.
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Embedded options: Call provision: grants the issuer the right to retire the debt, fully or partially, before the scheduled maturity date Put provision: gives the bondholder the right to sell the issue back to the issuer at par value on designated dates Convertible bond: provides the bondholder the right to exchange the bond for shares of common stock Exchangeable bond: allows the bondholder to exchange the issue for a specified number of common stock shares of a corporation different from the issuer of the bond

Higher yield, lower bond price Higher coupon rate, higher price Longer period, higher impact of yield on price

Modified duration = The approximate percentage change in price for a 100-basis-point change in yield.

Risk associated with investing in mortgage loans: 1. Credit risk: is the risk the homeowner/borrower will default. An investor who purchases securities backed by a pool of mortgage loans may or may not be concerned with the credit risk associated with the borrowers whose loans are backing the security. 2. Liquidity risk: Although there is an active secondary market for mortgage loans, the fact is that bid-ask spreads are large compared with other debt instruments (i.e. mortgage loans tend to be rather illiquid because they are large and indivisible). 3. Interest rate risk: Because a mortgage loan is a debt instrument and long-term on the average, its price will move in the direction opposite to market interest rates. Moreover, because the borrower can repay the loan at any time, the investor faces the same problem of negative convexity when rates decline as that of the holder of any callable bond. 4. Prepayment risk: The mortgage investors face this risk when interest rates either go up or down. When interest rate decreases, borrowers tend to increase their prepayment, causing investors to reinvest at lower rates. However, when interest rate goes up, it becomes more expensive for borrowers to increase their repayment so investors cannot reinvest at that high level of interest rate. The effect of prepayments is that the cash flow from a mortgage is not known with certainty. Prepayments occur for one of several reasons. First, homeowners prepay the entire mortgage when they sell their home. The sale of a home may be due to (1) a change of employment that necessitates moving, (2) the purchase of a more expensive home (trading up), or (3) a divorce in which the settlement requires sale of the marital residence. Second, the borrower has the right to pay off all or part of the mortgage balance at any time. Effectively, someone who invests in a mortgage has granted the borrower an option to repay the mortgage and the debtor will have an incentive to do so as market rates fall below the contract rate. Third, in the case of homeowners who cannot meet their mortgage obligations, the property is reposed and sold. The proceeds from the sale are used to pay off the mortgage in the case of a conventional mortgage. For an insured mortgage, the insurer will pay off the mortgage balance. Finally, if property is destroyed by fire or another insured catastrophe occurs, the insurance proceeds are used to pay off the mortgage.

2. In what sense has the investor in a residential mortgage loan granted the borrower (homeowner) a loan similar to a callable bond? Answer: Prepayment risk is the risk associated with a mortgages cash flow due to prepayments. More specifically, investors are concerned that borrowers will pay off a mortgage when prevailing mortgage rates fall below the loans note rate. For example, if the note rate on a mortgage originated five years ago is 8% and the prevailing mortgage rate (i.e., rate at which a new loan can be obtained) is 5.5%, then there is an incentive for the borrower to refinance the loan. The decision to refinance will depend on several factors, but the single most important one is the prevailing mortgage rate compared to the note rate. The disadvantage to the investor is that the proceeds received from the repayment of the loan must be reinvested at a lower interest rate than the note rate. This risk is the same as that faced by an investor in a callable corporate or municipal bond. However, unlike a callable bond, there is no premium that must be paid by the borrower in the case of a residential mortgage loan. Any principal repaid in advance of the scheduled due date is paid at par. 3. Answer the below questions. a) What is meant by prepayments due to housing turnover? Answer: Housing turnover means existing home sales. The two factors that impact existing home sales include (1) family relocation due to changes in employment and family status (e.g., change in family size, divorce), and (2) trade-up and trade-down activity attributable to changes in interest rates, income, and home prices. In general, housing turnover is insensitive to the level of mortgage rates. b) What is meant by prepayments due to cash-out refinancing? Answer: Cash-out refinancing means refinancing by a borrower in order to monetize the price appreciation of the property. Prepayments due to cash-out refinancing will depend on the increase in housing prices in the economy or region where the property is located. Adding to the incentive for borrowers to monetise price appreciation is the favourable tax law regarding the taxation of capital gains. The federal income tax rules exempt gains up to $500,000. Thus, cash-out refinancing may be economic despite a rising mortgage rate and considering transaction costs. Basically, cash-out refinancing is more like housing turnover refinancing because of its tie to housing prices and its insensitivity to mortgage rates.

c) What is meant by prepayments due to rate/term refinancing? Answer: Rate/term refinancing means that the borrower has obtained a new mortgage on the existing property to save either on interest cost or shortening the life of the mortgage with no increase in the monthly payment. The homeowners incentive to refinance is based on the projected present value of the dollar 6 interest savings from the lower mortgage rate after deducting the estimated transaction costs to refinance. RMBS = Resident Mortgage Backed Securities CMO = Collateralised Mortgage Obligation ABS = Assets Backed Securities CDO = Collateralised Debt Obligation

Usually there is some chance that an American option will be exercised early. An exception is an American call on a non-dividend paying stock. This should never be exercised early. Reasons for not exercising a call early (no dividends): - No income is sacrificed - You delay paying the strike price - Holding the call provides insurance against stock price failing below strike price

Explain what is meant by the following terms: a. Complete markets Answer: If a market has M states, we can say it is complete when it contains M assets which are linearly independent. In this context, one can build up a portfolio for any arbitrary asset If all possible assets can be created in a market, the market is said to be complete. A complete market has at least as many assets as states. If the number of assets exceeds the number of states, then there are redundant assets in the market. In a complete market with m assets and n states, m n, there are m-n redundant assets. b. Redundant asset Answer: Assets that are linear combinations of other securities are called redundant, i.e. they can be replicated from other assets in the market. c. Arrow-Debreu asset Answer: Suppose a market has M states, the Arrow-Debreu asset for state J has a payoff of 1 in state J and 0 in all other states (here J is no bigger than M). Therefore there are M Arrow-Debreu assets for the market. (Also show the mathematical expression of the Arrow-Debreu assets with payoff vectors.). This can be used to determine the price of a state the pricing kernel. d. Type I arbitrage: Suppose you have two assets (or portfolios) and one pays more in each state. This asset (portfolio) should be worth more. Type I arbitrage allows us to exploit such inconsistencies. Type I arbitrage exploits the mispricing of linearly independent assets. e. Type II arbitrage: For Type II arbitrage, assets must be linearly dependent, i.e. redundant. Type II arbitrage exploits the mispricing of redundant asset. f. Arbitrage pricing theorem: If no w > 0 exists, arbitrage opportunities are present If w is unique, the market is complete If the price of b is unique, it is redundant

5. a) A banks assets and liabilities both have duration of 5 years. Is the bank hedged against interest rate movements? Explain carefully any limitations of the hedging scheme it has chosen. [7 marks] Answer: Limitations relate to possibility of non-parallel shifts in the term structure. You can give examples of assets earning a floating rate while liabilities paying fixed rate (and vice versa) to show interest rate exposure. b) Explain what is meant by basis risk in the situation where a company knows it will be purchasing a certain asset in two months and uses a three-month futures contract to hedge its risk. [7 marks] Answer: Basis risk arises from the difference between spot and futures price in 2 months Define: F1: Futures price at time hedge is set up F2: Futures price at time asset is purchased (two months) S2: Asset price at time of purchase (two months) b2: Basis at time of purchase (two months) Net amount = S2 (F2 F1) =F1 + b2 You can give a numerical example to describe b in a real case scenario 6. a) Give an example of how a swap might be used by a portfolio manager. [8 marks] Answer: A swap could be used to change an asset earning (liability paying) a fixed rate of interest to one earning a floating rate. An example is shown in Lecture 9 slide 34/35 (32/33 for liabilities) b) Explain the nature of the credit risks to a financial institution in a swap agreement. [8 marks] Answer:

Credit risks arise from the possibility of a default when the swap has a positive value and the counterparty defaults. It can be mitigated by Netting positions, Collateralization, Downgrade trigger clauses or by using credit derivatives (definitions in Lecture 10 slides 12-15) LIBOR SWAP CURVE