Fixed Income Analysis

Course Code BA(MBA-INV)-722

Submitted to Mr. Shoaib Hashmi
Submitted by : Asfia Jawaid Siddiqui
 Overview of Bond Sectors &
Instruments

Assignment: Solve the following questions from the handout (4,5 and 13)

Question no 04

Suppose a portfolio manager purchases $1 million of par value of a Treasury inflation

protection security. The real rate (determined at the auction) is 3.2%.

A. Assume that at the end of the first six months the CPI-U is 3.6% (annual rate).Compute the following

(i) Inflation adjustment to principal at the end of the first six months,
(ii) The inflation-adjusted principal at the end of the first six months
(iii) The coupon payment made to the investor at the end of the first six months.

B. Assume that at the end of the second six months the CPI-U is 4.0% (annual rate). Compute the
following

(i) Inflation adjustment to principal at the end of the second six months
(ii) The inflation-adjusted principal at the end of the second six months
(iii) The coupon payment made to the investor at the end of the second six months.

Solution
A. Since the inflation rate (as measured by the CPI-U) is 3.6%, the semiannual inflation rate for adjusting
the principal is 1.8%.
(i) The inflation adjustment to the principal is $1,000,000 × 0.018% = $18,000
(ii) The inflation-adjusted principal is $1,000,000 + the inflation adjustment to the principal
= $1,000,000 + $18,000 = $1,018,000
(iii) The coupon payment is equal to inflation-adjusted principal × (real rate/2)
= $1,018,000 × (0.032/2) = $16,288.00

B. Since the inflation rate is 4.0%, the semiannual inflation rate for adjusting the principal is 2.0%.
(i) The inflation adjustment to the principal is $1,018,000 × 0.02% = $20,360
(ii) The inflation-adjusted principal is $1,018,000 + the inflation adjustment to the principal
= $1,018,000 + $20,360 = $1,038,360
(iii) The coupon payment is equal to inflation-adjusted principal × (real rate/2)
= $1,038,360 × (0.032/2) = $16,613.76
 Question no 05

Suppose that a 15-year mortgage loan for $200,000 is obtained. The mortgage is a level-payment,
fixed-rate, fully amortized mortgage. The mortgage rate is 7.0% and the monthly mortgage payment is
$1,797.66.

a. Compute an amortization schedule for the first six months.

b. What will the mortgage balance be at the end of the 15th year?
c. If an investor purchased this mortgage, what will the timing of the cash flow be assuming that
the borrower does not default?

Solution

a. Monthly mortgage payment = $1,797.66

Monthly mortgage rate = 0.00583333 (0.07/12)

b. In the last month (month 180), after the final monthly mortgage payment is made, the
ending mortgage balance will be zero. That is, the mortgage will be fully paid.

c. The cash flow is unknown even if the borrower does not default. This is because the borrower has
the right to prepay in whole or in part the mortgage balance at any time.
 Question no 13
a. What is a collateralized debt obligation?
b. What distinguishes an arbitrage transaction from a balance sheet transaction?

Solution

a. A collateralized debt obligation is a structure backed by a portfolio of one or more fixed income
products—corporate bonds, asset-backed securities, mortgage-backed securities, bank loans, and
other CDOs. Funds are raised to purchase the assets by the sale of the CDO. An asset manager manages
the assets.

b. The distinction between an arbitrage transaction from a balance sheet transaction is based on the
motivation of the sponsor of the CDO. Arbitrage transactions are motivated by the objective to capture the
spread between the yield offered on the pool of assets underlying the CDO and the cost of borrowing which
is the yield offered to sell the CDO. In balance sheet transactions, typically undertaken by financial
institutions such as banks and insurance companies, the motivation is to remove assets from the balance
sheet thereby obtaining capital relief in the form of lower risk-based capital requirements.