Subu-CFA Level 1 - Fixed 199 terms skonar

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What is Indenture ? - contract that specifies all rights and obligations of

issuer & owners of FI Security

Negative covenants restrictions on asset sales, negative pledge of collateral,

& restriction on additional borrowings.

Affirmative covenants the maintenance of certain financial ratios and the timely
payment of principal and interest.

Zero Coupon Bonds 1)Do not pay periodic interest. They pay the par value at
maturity 2)The interest results as they are initially sold at
discount 3)Also referred to as pure discount securities.

"Accrual bonds 1)They make no periodic interest payments prior to

maturity, 2)Sold originally at (or close to) par value.
3)There is a stated coupon rate, but the coupon interest
accrues (builds up) at a compound rate until maturity."

Step-up notes 1) Have a coupon notes that increase over time at a

specified rate.2)The increase may take place once or
more during the life of the issue.

Deferred-coupon 1) Initial coupon payments are deferred for some period

bonds 2) The coupon payments accrue, at a compound rate,
 over the deferral period. 3) After the initial deferment
period, these bonds pay regular coupon interest

Floating-rate securities 1) coupon interest payments vary based on a specified

interest rate or index 2) Usually LIBOR is used as
reference rate 3)New coupon rate = reference rate +/-
quoted margin

Inverse floater :- A floating-rate security with a coupon formula that

actually increases the coupon rate when a reference
interest rate decreases, and vice versa

Coupon Rate Cap: Maximum rate paid by borrower/issuer

Coupon Rate Floor minimum periodic coupon interest payment recieved by

lender/ security owner

Coupon Rate Collar Simultaneous presence of both cap and floor

Full (or Dirty) Price Total amount paid for bond, including accrued interest.

Full Price Clean Price + Accrued Interest

Bond trading "Flat" Bond trading without accrued interest due to issuer
being in default.

Non amortizing Bond pays only interest until maturity, at which the entire par
or face value is repaid. This repayment structure is
referred to as "bullet bond "or" bullet maturity.

Prepayment options : give the issuer/borrower the right to accelerate the

principal repayment on a loan.

Call provisions give the issuer the right (but not the obligation) to retire
all or a part of an issue prior to maturity.

Nonrefundable bonds prohibit the call of an issue using the proceeds from a
: lower coupon bond issue. Thus, a bond may be callable
but not refundable.

A Non callable bond has absolute protection against a call prior to maturity

Which Call provision Call protection period

gives investors
protection against call
risk

A callable but refunding.

nonrefundable bond
can be called for any
reason other than

Redeemed When bonds are called through a call option or through

the provisions of a sinking fund.

Refunded If a lower coupon issue is sold to provide the funds to

call the bonds

Sinking fund provisions provide for the repayment of principal through a series
: of payments over the life of the issue

"Sinking-Fund issuer deposits cash with trustee who retires applicable

Provisions- Cash proportion of bonds at par using lottery selection.
Payment:

Delivery of Securities Issuer purchases bonds with equal total par value in the
market and delivers them to trustee who will retire them."

Regular redemption When bonds are redeemed under the call provisions
specified in the bond indenture

Special redemption when bonds are redeemed to comply with a sinking fund
provision or because of a property sale mandated by
government authority

Investor options conversion features, put provisions, and floors

include :

Issuer options include : call provisions, prepayment options, sinking fund

provisions, and caps

In Margin buying : one borrows funds from a broker or a bank to purchase

securities and the securities themselves are the collateral
for the margin loan.

What is a Repo? Arrangement where an institution sells a security with a

commitment to buy it back at a later date at a specified
higher price.

How do you find Repo The annualized percentage difference between lender's
Rate? purchase and sell back price.

Why are Repo They are not regulated by the Fed Reserve and it
issuances preferred provides a better collateral position for the lender if the
among lenders? seller goes bankrupt. Lender has only an obligation to
 sell back the repo rather than stake a claim against
seller's assets

Type of Risk : 1) Interest rate risk, 2) Yield curve risk 3) Call risk 4)
Prepayment risk 5) Reinvestment risk 6) Credit risk 7)
Liquidity risk: 8) Exchange-rate risk 9) Inflation risk,
10)Volatility risk 11)Event risk 12) Sovereign risk

Ø Coupon Rate > YTM Premium bond

Coupon Rate < YTM Discount Bond

Coupon Rate YTM = Par Bond

Duration formula: (% change in bond price) / (%change in yield)

Portfolio duration the combined weighted averages (based on market

value) of the bonds that make up the portfolio

Portfolio Duration a good measure for parallel shift in the yield curve

Call Risk Risk of investor's principal being returned when interest

rates fall, and as a result reinvesting at a lower rate.

Credit Risk Risk of issuer's creditworthiness deteriorating, increasing

required return and decreasing the security's value.

Event Risk Risks outside the financial markets like natural disasters,
and corporate takeovers, etc.

Exchange rate Risk Risk from uncertainty about the value of foreign currency
cash flows to an investor in terms of home country
currency.

inflation risk Better described as "unexpected" inflation risk or

purchasing power risk.

Interest Rate Risk The effect of changes in the prevailing market rate of
interest on bond values. i.e. When rate goes up, bond
prices fall.

Liquidity Risk Risk of security having to be sold for less than market
value due to lack of liquidity.

Prepayment Risk Similar to Call Risk, risk of prepayment when interest

rates fall, requiring investor to reinvest at a lower rate.

Reinvestment Risk Risk of reinvesting principal and interest cash flows at

lower rates reducing investor returns.
Volatility risk is the effect on bond values with embedded options.

Type of Event Risk 1) Disaster 2) Corporate Restructuring 3) Regulatory

Issues

Yield curve risk risk to bondholders that the shape of the yield curve will
change (relation between bond yields and maturity)

"What do changes in Yields are changing by different amounts for bonds with
the shape of the Yield different maturities."
Curve tell investors

What does a bond's The interest rate risk of a bond, or parallel changes in the
duration tell us yield curve (rate changes at every maturity).

What measure Duration

approximates the
interest rate risk on
bonds

What term can be use Duration

to describe the ratio of
the percent change in
price to change in
yield in percent for a
bond

Interest rate risk is reset date

highest 1 day after

What happens to the Price returns to par.

price of a no-cap
floating rate security
on its reset date,
ceterus paribus

Floating-rate security Thus lesser duration.

will have much less
sensitive to changes in
market yields than a
fixed-coupon bond of
equal maturity

The longer the time Thus greater the duration.

period between the
two dates(coupon
reset period), the
greater the amount of
potential bond price
fluctuation
Effect on interest rate interest rate risk increases
risk or duration-
maturity increases

effect on interest rate interest rate risk decreases

risk or duration -
coupon increases

"Do non-callable Yes, since the coupon interest

coupon bonds have
reinvestment risk
before maturity

payments must be reinvestment risk

reinvested, those cash
flows are subject to

"Do non-callable zero- No, since there are no cash flows to reinvest until
coupon bond have maturity.
reinvestment risk
before maturity

Callable Bond Less Certain Cash Flow, Cap on price appreciation,

Disadvantages Reinvestment risk

Security has more re- The coupon is higher so that interest cash flows are
investment risk when higher 2) It has a call feature 3) It is an amortizing
security. 4) It contains a prepayment option

Yield on Risky Bond Yield on Default Free Bond + Credit Spread

Current yield (annual cash coupon payment) / (market price of bond)

Dollar duration dollar change in bond price for a 1% change in yield

"What is the Positive

relationship between
interest rate volatility
and Call or
Prepayment Risk

Increase in yield increase value of call option & decrease the market
volatility value of callable bond

Value of a Callable Value of Option Free Bond - Value of Call

Bond

Increase in yield increase value of pull option & increase the market value
volatility of putable bond

Value of a Putable Value of Option Free Bond + Value of Put

Bond

How Central Govt 1) Regular Cycle Auction-Single Price 2) Regular Cycle

Issue Sovereign Bond Auction - Multiple Price 3) Ad Hoc auction System 4)
Tap System

T-bills 1) 3 Maturity cycle - 4 weeks, 1 month & 3 Months. 2)

Carry No Coupon & sold at discount

T-Notes 1) 2,3,5 & 10 years Maturity 2) Carry Coupon & Non-

Callable

T-Bonds Bonds has maturity of more than 10 year( 20 to 30 years).

Non-Callable

TIPS - 5 & 10 yrs Notes & 20 yrs bonds offered by treasury

On-the-run issues are the most recently auctioned Treasury issue, also
known as the current issue.

Off-the-run issues are older issues that have been replaced by a more
recently auctioned issue.

Treasuries with several well off-the-run

subsequent issues are
termed

Coupon strips strips created from coupon payments stripped from the
(denoted as ci) refers original security.
to

Principal strips refers to bond and note principal payments with the coupons
stripped off. Those derived from stripped bonds are
denoted bp and those from stripped notes (np)

Type of Fed Agency 1)Federally Related Institution(Ginnie Mae, TVA)

Govt sponsored Federal Farm Credit System, Fed Home Loan Bank
enterprise System, Fannie Mae, Freddic Mae, Sallie Mae)
GSEs commonly issue debentures.

CMO Creation 1)Redistribute the prepayment risk 2)create security with

Motivation different maturity

GO bonds are backed by the full faith, credit, and taxing power of
the issuer

Type of GO Debt 1) Limited Tax GO 2) Unlimited Tax GO 3) Double

Barreled Bond 4)appropriation Backed
Obligation//Moral Obligation Bonds

Revenue bonds are supported only through revenues generated by

projects that are funded with the help of the original
bond issue.

Insured Bond Carry the guarantee of third party for timely payment of
principal & interest

Prefunded Bond Treasury purchase & place in separate escrow a/c in an

amt sufficient to make all remaining bond payment

Secured Debts is 1) Personal property(e.g Machinery) 2) Real Property 3)

backed by Financial Assets

Bonds backed by Collateral Trust Bonds

financial assets are
called

Unsecured Debts is Debentures

referred as

Credit enhancement - 1) Third Party Guarantees 2) Letter of Credit 3)Bond

form are Insurance

Medium Term notes 1) Register with SEC Rule 415(Shelf Registration)

2)Maturity - 9 months to 100 years 3) Combined with
Derivatives is called structured security 4)Agents does
on best effort basis

Type of Structured 1) Step up notes 2)Inverse Floaters 3)Deleveraged

Medium Term Notes floatres 4) Dual indexed floaters 5)Range Notes 6)Index
Amortizing Notes

Commercial paper is a short-term unsecured debt instrument used by

corporations to borrow money at rates lower than bank
 rates. CP has maturities from 2 - 270 days; unregulated
by the SEC

Directly-placed paper is commercial paper that is sold to large investors

without going through an agent or broker-dealer

Dealer-placed paper is sold to purchasers through a commercial-paper

dealer.

Certificates of deposit are issued by banks and sold to their customers.They

(CDs) represent a promise by the bank to repay a certain
amount plus interest and, in that way, are similar to other
bank deposits..

Bankers acceptances are essentially guarantees by a bank that a loan will be

repaid. They are created as part of commercial
transactions, especially international trade.

Credit card balances, asset backed securities (ABS).

auto loans, receivables
etc. can also be
securitized like
residential mortgages
into what are known as

SPV is a bankruptcy Meaning no claim to SPV if Corporation goes bankrupt

Remote entity

Credit enhancement 1) Corporate Guarantees 2) Letter of Credit 3)Bond

form for ABS(CLB) Insurance

Collateralized debt CDOs are debt securities for which the underlying
obligations collateral is itself other debt (loans, mortgages, bonds,
other CDOs, etc.)

1) arbitrage CDOs creator hopes to profit from spread between cash flows
to be received on underlying assets and payments made
by CDO

2) balance sheet CDOs used to reduce debt exposure on firms' balance sheets

Interest rate tool of 1) The discount rate 2) Open market operations. (Most
FED Often Used) 3)Bank reserve requirements 4) Persuading
banks to tighten or loosen their credit policies

A normal yield curve Long-term rates are greater than short-term rates, so the
 curve has a positive slope.
A flat yield curve The yield on all maturities is essentially the same.

An inverted yield Long-term rates are less than short-term rates, thus yield
curve curve a negative slope.

A humped yield curve Rates in the middle spectrum are higher or lower than
those for both short and long maturity bonds.

Pure Expectation It states that the yield for a particular maturity is an

Theory average(not a simple average) of the short term rates
that are expected in future

If short term rate are higher than short term & Curve will slope upward
expected to rise, then
Long term yield will be

Short Term rate Upward Sloping Curve

expected to rise in
future

Short Term rate downward Sloping Curve

expected to fall in
future

Short Term rate Humped Yield Curve

expected to rise then
fall

Short Term rate - Flat Yield Curve

expected to remain
constatn

Liquidity preference States that investors require a risk premium ,in addition to
theory expectations about future short term rates for holding
longer term bonds .This is consistent with the fact that
interest rate risk is greater for longer maturity bond

Market Segmentation States that investors and borrowers have preferences for
Theory different maturity ranges. Thus the supply of bonds
(desire to borrow) and demand for bond(desire to lend)
determine equilibrium yields for various maturity ranges.

The appropriate Spot Rates

discount rates for
individual future
The absolute yield simply the difference between yields on two bonds.
payment are called
spread

Absolute yield spread [yield on the higher-yield bond / yield on the lower yield
bond]

The relative yield absolute yield spread expressed as a percentage of the

spread is yield on the lower-yield bond.

Relative Yield Spread [Absolute Yield Shield/Yield on Benchmark bond]

"The yield ratio is the of the yields on the two bonds(Given security to
ratio Benchmark Security).

Yield Ratio Higher yield / Lower yield

Absolute yield spreads basis points (100ths of 1%).

are usually expressed
in

For liquidity - Large more Liquidity

issue size result in

The yield on a taxable the after-tax yield,

bond, after adjustment
for federal income
taxes, is called

After-tax yield (taxable)pre-tax yield × (1 - marginal tax rate)

Formula Taxable-equivalent yield = tax-free yield / (1 - marginal

tax rate)

LIBOR determined each day and published by the British

Bankers'Association for several currencies, including the
U.S,Canadian,and Australian dollars, the Euro, Japanese
yen, British pounds, and Swiss francs, among others

Bond Valuation 1) Estimate the Cash Flow(Prin & Coupon) 2) Determine

Process the appropriate discount rate 3) Calculate the present
value of the estimated cash flows

Problem in estimation 1) Uncertainity of Principal Cash Flow 2) Uncertainity of

of Cash flow Coupon Cash Flow 3) Bond Convertible/exchangeable

Yield on Risky Bond Yield on Default Free Bond + Risk Premium(Credit

Spread)
Bond Value & Bond inversely related
Yield are

Current yield is coupon cash flow, but does not consider capital
concerned only with gains/losses or reinvestment income.

PV of ZCP Maturity Value/(1+i) numbers of years*2 [ I is semiannual

coupon rate]

Explicit paying Debt 1) Coupon Interest Payment 2)Recovery of prin along

Security Returns with capital gain/loss 3)Reinvestment income( from
investing coupon payments )

Current yield is coupon cash flow, but does not consider capital
concerned only with gains/losses or reinvestment income [

current Yield Annual Cash Coupon Payment/Bond Price]

Yield to maturity (YTM) measures the internal rate of return to a bond.

annualized IRR of a bond based on its price and cash
flow. It is the most popular of all yield measures used in
the marketplace .

Yield to call (YTC) Investors are typically interested in knowing what the
yield will be if the bond is called by the issuer at the first
possible date. This is called yield to first call or yield to
call (YTC).

Yield to first par calculated in exactly the same way, except that the
call(YTFPC) number of years is to first par call, and FCP becomes par
value.

"Yield to put (YTP) Some bonds may be put (sold back to the issuer prior to
maturity) at the option of the holder. Investors are
typically interested in knowing what the yield will be if
the bond is put to the issuer at the first possible date.
This is called yield to put (YTP)

Yield to worst (YTW) involves the calculation of YTC and YTP for every
possible call or put date, and determining which of these
results in the lowest expected return. Least attractive
yield option when bond has called option

Cash flow yield (CFY) incorporates a projection as to how these prepayments

are likely to occur. Once we have this in hand, we can
 calculate CFY via an internal rate of return measure,
similar to the YTM

Yield to refunding refer to specific situation where bond is currently

callable & current rate make callable attractive to issuer,
but covenants contain provision against refunding until
some future date

Cash Flow yield (CFY) is use for MBS & other amortizing securities

formula BEY of an [(1 + annual YTM)1/2 - 1] × 2

annual-pay bond

Equivalent annual yield [1 + (YTM/2)]2 - 1

If the reinvestment rate the realized yield on the bond will be less than the YTM.
is <YTM,

The realized yield will the assumed reinvestment rate

always be between the
YTM and

Reinvestment Risk 1) Coupon is Higher 2) Longer Maturities

increase if

Nominal spread A bond's YTM - the YTM of a similar treasury security

YTM uses a single value the cash flows, so it ignores the shape of the spot
discount rate to yield curve.

Yield to maturity (YTM) annualized IRR of a bond based on its price and cash
flow

Z Spread It is the equal an amount which must be added to each

rate on the Treasury spot yield curve in order to make
the present value of the risky bond's cash flows equal to
its market price

Z Spread - The steeper the benchmark spot rate curve, the greater
the difference between the two spread measures

Z Spread The earlier bond principal is paid, the greater the

difference between the two spread measures

Option Adjusted Use when bonds has embedded options

Spread(OAS)
The OAS is the spread were option-free
to the Treasury spot
rate curve that the
bond would have if it

The OAS is the spread credit risk, liquidity risk, and interest rate risk.
for non-option
characteristics like

Z-spread - OAS = option cost in %

For Put Option Z- < OAS

spread

Forward rate is a borrowing/lending rate for a loan to be made at

some future date.

Forward rates are spot rates of the yield curve

calculated from

(1+ S3)3 (1 + 1f0) (1 + 1f1) (1 + 1f2) & (1+ S3)3 = (1 + S2)2 (1 + 1f2)

The full valuation the re-valuation of a bond for a range of interest rate
approach requires changes

The duration/convexity utilizes the measure of duration combined with convexity

approach to estimate the percentage price change of a bond for a
given change in interest rates

The relation between negative

price and yield for a
straight coupon bond
is

With a callable or pre- limited

payable debt the
upside price
appreciation in
response to
decreasing yields is

With a Put-able debt, limited

the downside price in
response to increasing
yields is
The increase in bond This is positive convexity
price when yield
decreases is more than
decrease in bond
price when yield
increases.

Callable or pre- This is the concept of negative convexity

payable debt, the
upside price
appreciation in
response to
decreasing yields is
limited as once the
bond reaches the call
price the price wont
appreciate.

Similarly for bonds high yields.

with put option the
negative convexity
phenomenon occurs at

Effective duration (Bond price when yield fall-bond price when yield
rise)/2(initial Price)(Change in yield in decimal form)

Effective Duration is the preferred measure because it gives a good

approximation of interest rate sensitivity for both option-
free bonds and bonds with embedded option.

Macaulay duration is an estimate of a bond's interest rate sensitivity based

on the time, in years, until promised cash flows will
arrive. Not useful measure for bonds with embedded
options

Modified Duration is derived from macaulay duration and offers slight

improvement over Macaulay duration in that it takes the
current YTM into account.Not useful for bonds with
embedded options

The duration of a simply the weighted average of the durations of the

portfolio is individual securities in the portfolio

"Portfolio duration w1D1 + w2 D2 + ... +WNDN where:

Limitations of Portfolio 1) limitations of portfolio duration as a measure of
duration interest rate sensitivity stem from the fact that yields may
not change equally on all the bonds in the portfolio
2)Useful only for parallel changes of yield curve

Convexity Effect 1) Convexity is a measure of the curvature of the price-

yield curve. The more curved the price-yield relation is,
the greater the convexity.

2) A straight line has a zero. If the price-yield curve were, in fact, a straight line,
convexity of the convexity would be zero.

The reason we care the worse our duration-based estimates of bond price
about convexity is that changes in response to changes in yield are.
the more curved the
price-yield relation is

The greater the the greater the error in price estimates based solely on
convexity duration.

"percentage change in duration effect + convexity effect

price

"percentage change in = {[-duration × ▲y)] + [convexity × ▲y)2 ]} × 100

price formula

Effective convexity embedded options, while modified convexity does not

takes into account
changes in cash flows
due to

The difference the difference between modified duration and effective

between modified duration
convexity and
effective convexity
mirrors

Price Value of a Basis = (duration) (.001) (bond value)

Point =