2021 LI FixedIncome

Last Revised: 12/15/2020
MarkMeldrum.com
Level I - Fixed Income

Readings Page
Fixed-Income Securities: Defining Elements 2
Fixed-Income Markets: Issuance, Trading, and Funding 15
Introduction to Fixed-Income Valuation 26
Introduction to Asset-Based Securities 42
Understanding Fixed-Income Risk and Return 63
Fundamentals of Credit Analysis 78
Reviews 86
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1
Prepared exclusively for susana serna ,tuti_ese@hotmail.com Transaction: 0079224436,
Fixed-Income Securities: Defining Elements
a. describe basic features of a fixed-income security;
b. describe content of a bond indenture;
c. compare affirmative and negative covenants and identify examples of each;
d. describe how legal, regulatory, and tax considerations affect the issuance
and trading fixed-income securities;
e. describe how cash flows of fixed-income securities are structured;
f. describe contingency provisions affecting the timing and/or nature of cash

flows of fixed-income securities and identify whether such provisions
benefit the borrower or the lender.
2
Fixed - Income Securities: Defining Elements

LOS a
→ any borrowing of money is debt (fixed income security) -describe
- promised payments are contractual obligations Pg-1
- payment of interest and principal are a prior claim on the
company’s earnings and assets versus equity
Bond → a contractual agreement between the issuer & bondholders
⇒ Basic Features/
1/ Issuer
Supranational organizations (World Bank)
gov’t Governments → sovereign
dfdf (national)
sector → non-sovereign (state, provincial, municipal)
→ quasi-government (government owned or
corporate sponsored agencies)
sector Companies (corporate, either financial or non-financial)
structured special purpose entities (securitization → ABS, MBS)

finance
sector
⇒ Basic Features/ LOS a

2/ Maturity - maturity date → principal due -describe
- tenor → time remaining to maturity date Pg-2
- range → from overnight to 30 years (or longer)

• money market securities - maturities, at issuance, <1yr
(e.g. commercial paper, CDs, T-Bills)
• capital market securities - maturities, at issuance, >1yr
• perpetual bonds - no maturity (consols)
3/ Par Value a.k.a. principal amount, principal value, future value, maturity
value, face value, nominal value, redemption value
- bonds can have any par value 100 - par bond
- bonds are typically quoted as a percentage of par 98 - discount bond
104 - premium bond
3

-describe
4/ Coupon Rate & Frequency
Pg-3
• coupon → annual amount of interest payments made
(coupon rate × par value)
e.g./ 6%, $1000 bond ⇒ $60 annually typically gov’t, corporate
$30 semi-annually
$15 quarterly QUIBS - quarterly interest bonds
$5 monthly QUIDS - quarterly interest debt
MBS securities
• plain vanilla or conventional bond – fixed coupon
• floating rate notes (FRNs, floaters) - a reference rate + a spread
pays pays pays
fluctuates constant
London 4.75% 4.65% 4.50%
(e.g. Libor) (in bps)
Interbank Dec June Dec June
offered 3.25 3.15 3.00 2.95
rate (Libor) e.g. Libor + 150 bps

4/ Coupon Rate & Frequency -describe
Pg-4
no coupon payments - sold at a discount
• zero-coupon bond all income = interest
most money market securities = zero coupon
5/ Currency Denomination - can be issued in any currency

EM countries typically opt to issue either USD or EUR denominated bonds
- makes it easier to place the bond
- dual-currency bonds → coupon payments in one currency
→ principal payments in another
- currency-option bonds → single currency bond bondholders choose the
+ currency of each interest
foreign currency option payment & principal
4
⇒ Yield Measures/ current or running yield 𝐚𝐧𝐧𝐮𝐚𝐥 𝐜𝐨𝐮𝐩𝐨𝐧 LOS a

-describe
𝐩𝐫𝐢𝐜𝐞
Pg-5
• yield-to-maturity (yield-to-redemption,
redemption yield)
- the IRR of the bond’s expected cash flows
→ an estimate of the bond’s expected return
→ inverse relationship between price and YTM
→ higher price, lower YTM
→ lower price, higher YTM
par bond → coupon rate = YTM
premium bond → coupon rate > YTM
discount bond → coupon rate < YTM
⇒ Bond Indenture LOS b

- trust deed → legal contract - form of the bond -describe
Pg-6
- obligations of the issuer
guided by - rights of the bondholder
issuer trustee → typically a financial institution with trust

appoints
powers
acts as a
monitors fiduciary for
for compliance bondholders
• trust deed includes/

1/ Legal identity of the bond issuer and its legal form
Holding Co. Securitization
credit
transfers
Co. A Co. B Co. C quality &
assets to
recourse
Subs. of bankruptcy
to assets
Co. A SPE remoteness
Co. A
from Co. A
bondholders
5

-describe
2/ Sources of repayment proceeds
Pg-7
• Supranational → repayment of previous loans
→ paid-in capital from its members
tax revenues
• Government → Sovereign → full ‘faith and credit’
print money
→ Non-Sovereign → taxes
→ project cash flows
→ special taxes/fees specific to the
funding
• Corporate → CFO
• Securitized → periodic payments of principle + interest from
securities held
3/ Asset or Collateral Backing
A/ Senior Ranking → secured bond → backed by assets (less risky)
→ unsecured bond → general pledge
senior
junior
• Debenture - can be secured or unsecured

3/ Asset or Collateral Backing -describe
Pg-8
B/ Types of Collateral Backing
• Collateral Trust Bond - backed by other financial assets (held by a trustee)
• Equipment Trust Certificate - backed by specific equipment
- typically used to engineer a lease
➃ pays issues ➀
Airline Trustee Certificate
leases $
➂ buys
assets ➁
• MBS - backed by a pool of mortgages
• Covered bonds - backed by a segregated pool of assets that are not
transferred to a SPE
- if the assets become non-performing, must be replaced
by other assets
6
LOS b
⇒ Bond Indenture
-describe
4/ Credit Enhancements - reduce the credit risk of a bond Pg-9
a) Internal subordination or credit tranching junior – last paid
overcollateralization senior 2
- posting more collateral senior 1
than is needed ‘waterfall structure’
reserve accounts or reserve funds
• cash reserve fund - a deposit of cash that can be used
➁
to absorb losses
• excess spread account e.g. 8% in, 6.5% out
b) External Bank guarantee and surety bonds – up to some percentage
(Bank) (Insurance Co.)
called the
• Letter of credit - a credit line to reimburse ‘penal sum’
any cash flow shortfalls from the assets
backing the issue
⇒ Bond Indenture LOS b, c

4/ Credit Enhancements -describe
b) External - cash collateral account - does not rely on 3 party -compare
rd
Pg-10
creditworthiness
5/ Covenants - legally enforceable rules
• Affirmative - typically administrative in nature
- what issuers are required to do
e.g./ What the issuer will do with the ➁proceeds, promise to comply with all
laws and regulations, maintain its current line of business, insure/maintain its
assets, pay taxes
• Negative - what an issuer will not do
- purpose is to protect bondholders
• Restriction on debt → max debt ratios, min. Interest Coverage Ratios
• Negative pledges → no debt senior to this issue
7
⇒ Bond Indenture LOS b, c

-describe
5/ Covenants · Negative
-compare
· Restrictions on prior claims (for unsecured bonds) - cannot use
Pg-11
unsecured assets for the future collateral
· Restrictions on distributions to shareholders - dividends and share
buybacks out of earnings above some threshold profit only
· Restrictions on asset disposal - set➁a limit on asset disposal
during bond’s life (% of gross assets)
· Restrictions on investment - blocks speculative investment
(i.e. stay in its current line of business)
· Restrictions on M & A - unless bond/collateral survive
- common element → ensure issuer will not take any actions that would
reduce its ability to make interest payments and repay the principal
→ Legal/Regulatory Considerations/ LOS d

· Domestic bonds - issued in issuer’s home country in the currency -describe
of that country (e.g. Can. Co. issues in Canada in CAD) Pg-12
· Foreign bonds - issuing entity not of the target country
(e.g. U.S. Co. issues in Canada in CAD)
- regulated by the market the bonds are issued in
· Euro bonds - originally created to bypass legal/regulatory/tax constraints
➁
imposed on issuers
- named after the currency in which they are denominated
e.g. Eurodollar, Euroyen
- less regulated since they are issued outside the jurisdiction of
any single country
- usually unsecured - can be issued in any currency
8
LOS d
→ Legal/Regulatory Considerations/
-describe
- global bonds → bonds issued simultaneously in the Eurobond
Pg-13
market and in at least one domestic market
- ensures sufficient demand for large bond issues
- domestic, foreign, Eurobond & global bonds are subject to different legal,
regulatory & tax requirements
- the market rate that affects a bond’s price is the currency in which the
bond is denominated ➁
⇒ Tax Considerations/
· Interest - typically taxed as ordinary income (unless tax-exempt)
· Capital gains/losses - long-term vs. short-term
favourable ordinary income

· Discount bonds - discount is amortized over life of bond and treated
as implied interest (opposite effect for premium bond) - but not always
LOS e
⇒ Bullet, Fully-amortizing, Partially amortizing bonds
-describe
Pg-14
- most common
- almost all gov’t
& corporate bonds
➁
(N = 5, PV = -1000, FV = 0, I/Y = 6) CPT PMT → 237.3964
- MBS → each
payment is fixed
‘interest + principal’
until paid in full
- reduces credit risk

over time
9
⇒ Bullet, Fully-amortizing, Partially amortizing bonds LOS e

-describe
Pg-15
N = 5, I/Y = 6, PV = -1000,
FV = 200
CPT PMT = 201.917
balloon payment required = $200

⇒ Sinking Fund arrangements/ - issuer sets aside funds over time to
retire the bond
- specifies the portion (e.g. 5%) of the bond’s principal outstanding
that must be repaid each year throughout the bond’s life
(or after a specified date)
⇒ Sinking fund arrangements/ LOS e

issuer trustee redeems bonds in open -describe
$ Pg-16
- also may involve redeeming some market or serial # lottery
increasing percentage each year
- lowers default (i.e. credit) risk, but raises re-investment risk or
call risk (called at par but trading at a premium)
⇒ Coupon payment structure/ annual
· Fixed coupon (conventional bond)➁ semi-annual certain
- price volatility quarterly cash-flows
monthly
· Floating rate notes - little price volatility since coupons are
reset at market rates on each coupon date
coupon = reference rate + spread (margin)
Uncertain cash flows
typically quarterly
10
⇒ Coupon payment structure/ LOS e

-describe
cap - maximum rate if both, called Pg-17
· Floating rate notes - may have
floor - minimum rate a collared FRN
· inverse or reverse FRN (inverse floater) - if the
reference rate ↓, coupon ↑ instead
· Step-up coupons - may be fixed or floating
- coupon increases by specified margins at specified dates
- offer bondholders some protection against rising rates
➁
· Credit-linked coupon bonds - coupon changes when bond’s credit
rating changes (↓/↑ by some margin with every ↑/↓
in credit rating)
· PIK (payment-in-kind) bonds - interest paid with more amounts
of the bond (or with common shares)
PIK toggle → issuer has the option to pay coupon
in cash or in kind (or some mix)
· usually tied to a cash flow trigger
LOS e
⇒ Coupon payment structure/
-describe
· Deferred coupon bonds (split coupon bonds) - no coupon Pg-18
payments for the first few years followed by higher coupon
than otherwise
- common in project financing (delay payments until the project
is complete)
· Index-Linked bonds - coupons are linked to some index
(e.g. inflation-linked bonds tied to CPI)
➁
with
without
Inf. Inf.
Inf.
real real real
real rate nominal nominal rate
decreases rate increases
· inflation adjustment can be made to either coupon
payments or principal
11
⇒ Coupon payment structure/ LOS e

· Index-Linked bonds -describe
Pg-19
· zero-coupon indexed bond → inflation adjustment via principal only
e.g./ $1000 face value → principal payment = $1,050
5% inflation
· interest-indexed bonds → fixed nominal principal + index-linked coupon
$1000 face value, 4% semi-annual coupon, 5% inflation
𝟏𝟎𝟎𝟎 ×. 𝟎𝟒
→ principal = $1,000 coupon = 8 : (𝟏. 𝟎𝟓) = $𝟐𝟏
𝟐
➁ + index-linked principal
· capital-indexed bonds → fixed coupon
∴ PMT ↑ as principal ↑
$1000 face value, 4% semi-annual coupon, 5% inflation
→ principal = $1000(1.05) = $1,050 𝐜𝐨𝐮𝐩𝐨𝐧 = 𝟏𝟎𝟓𝟎 × 𝟒%6𝟐 = $𝟐𝟏
· Indexed-annuity bonds → fully amortizing
→ interest + principal payments ↑ as CPI ↑
$1000 face value, 4% semi-annual coupon, 20 yr. bond, 5% inflation
(N = 40, I/Y = 2, FV = 0, PV = -1000) PMT = 36.56 → new PMT = 36.56(1.05) = 38.38
⇒ Bonds with contingency provisions/ LOS f

-describe
some future event or circumstance that is possible Pg-20
but not certain
- contingency provision gives issuer or bondholder a right to some action
1/ Callable Bonds - issuer has the right to embedded ‘option’

redeem all or part of the bond before maturity
- issuer is protected from a decline
➁ in interest rates
- can re-issue at lower rates
- call option has value to the issuer ∴ higher coupon or lower price
- detailed in the bond indenture:
compensates for higher
· call price · call dates
reinvestment risk
· call premium (shrinks as time passes)
· call protection period (lockout period) ⇒ cannot be called until
some future date
12
LOS f
⇒ Bonds with contingency provisions/
-describe
1/ Callable Bonds Pg-21
- make whole call → PV of 𝐚𝐥𝐥 𝐈𝐧𝐭. + 𝐏𝐫𝐢𝐧𝐜𝐢𝐩𝐚𝐥 - results in a
𝐠𝐨𝐯 ! 𝐭 𝐘𝐓𝐌 + 𝐬𝐩𝐫𝐞𝐚𝐝 call price > current
market price
- calls can be: American - continuously callable
European - only on call date (1 date)
Bermuda - only on call➁dates after the lockout period
- usually on coupon dates
2/ Putable bonds - bondholder can put bond back to issuer on certain dates
@ specific prices (value for bondholder)
- lower yield or higher prices
- protects against a rise in rates
→ one-time put bonds - European
→ multiple put bonds - Bermuda

-describe
3/ Convertible bonds - hybrid security, 5-10 yr. maturities
Pg-22
- bondholder has the right to exchange the bond for a
specified number of shares
- if share price ↓, get bond principal (downside protection)
- if share price ↑, get share price (upside participation)
- lower yield or higher price (yield higher than dividend yield however)
➁
- issuer pays lower interest, plus may avoid principal repayment
· Key Terms e.g.
· Conversion Price - price/share $20
· Conversion Ratio # of shares/bond 50 : 1
· Conversion Value P0 × conv. ratio P0 = 19, CV = 950
· Conversion Premium $Bond - Con. Value $1000 - 950 = 50
· Conversion Parity $Bond = Con. Value below par
13

3/ Convertible bonds -describe
Pg-23
- typically also have call provisions to force conversations
- avoids ‘overhanging convertibles’
when above parity
- bonds with warrants → attached warrants

→ not really a contingency provision, more of a
➁
yield enhancement
- contingent - convertible bonds → contingent write-down provisions
e.g./ if core Tier 1 capital falls below some
minimum level (min. Basel 3 requirement), bond
converts to equity → raises Tier 1 capital amount
- conversion happens automatically (not discretionary)
14
Fixed-Income Securities: Issuance, Trading, and Funding
a. describe classifications of global fixed-income markets;
b. describe the use of interbank offered rates as reference rates in floating-rate

debt;
c. describe mechanisms available for issuing bonds in primary markets;
d. describe secondary markets for bonds;
e. describe securities issued by sovereign governments;
f. describe securities issued by non-sovereign governments, quasi-government

entities, and supranational agencies;
g. describe types of debt issued by corporations;
h. describe structured financial instruments;
i. describe short-term funding alternatives available to banks;
j. describe repurchase agreements (repos) and the risks associated with them.
15
Issuance, Trading, Funding
⇒ Classification of Fixed-Income Markets/ LOS a

1/ by issuer · gov’t & gov’t related – supranational orgs. -describe
fin. Pg-1
· corporate - sovereign & non-sovereign
non-fin. - quasi-gov’t
· structured finance – securitization (MBS, ABS)

2/ by credit quality · Investment grade (Baa3 or BBB – and up)
· Non-Investment grade (high yield, speculative, junk)
- certain types of investors may be restricted from holding
non-investment grade debt
3/ by maturity · money market < 1 yr.
original maturity at issuance
· capital market > 1 yr.
4/ by currency – currency of a bond’s cash flows determines what
country’s interest rate affects price
5/ by coupon – fixed
- floating ➞ reference rate + spread
⇒ Classification of Fixed-Income Markets/ LOS a, b

-describe
5/ by coupon – floating rate = reference rate + spread
Pg-2
↓
Libor – reflects the rate at · resets · typically constant
which unsecured loans can periodically · set at issuance
be obtained between banks · typically Libor · f (credit risk)
in the Interbank Money Market ➞ is actually a collection of rates ranging
from overnight up to one year
Process/ 8-16 banks submit daily rates they believe they could
borrow at for 5 currencies and 7 time periods (35 rates)
USD, EUR, JPY, GBP, CHF 1 day, 1 wk., 1-2-3-6-12 months
- highest/lowest 25% discarded

LIBOR = mean of mid 50% of bids
- alternatives: Euribor, Tibor, Sibor, Hibor, Mibor
-
EUR JPY SGB HKD INR
16
LOS a
⇒ Classification of Fixed-Income Markets/ -describe
6/ by Geography · Domestic legal, regulatory and tax Pg-3
· Foreign issues of ‘issued-in’ country
· Eurobond - issued internationally
also by · developed market
· emerging market local currency
foreign currency
⇒ Primary bond markets/ - issuers initially sell bonds to investors LOS c
-describe
· Public Offerings
a) underwritten offerings (firm commitment offering)
Phases: 1. Issuer determines funding need
buys from
spread 2. Select underwriter – typically an investment bank
↓
= revenue (or syndicate)
lead
sells to syndicated
dealers/investors offering
LOS c
⇒ Primary bond markets/ -describe
· Public Offerings a) underwritten offerings Pg-4
3. Investment bank structures the offering
· bond terms · regulatory filings · circulators/prospectus
· selects trustee
4. Announcement date end of subscription period
- underwriter gauges demand + price
- marketing efforts
- anchors (large inst. investors)
- grey market (forward mkt.)
· pricing date
- last day to commit
- final terms solidified
· next day = offering
5. Issuing phase ⇒ money changes hands
6. Closing date ⇒ about 14 days from issue date
17
⇒ Primary bond markets/ LOS c

· Public Offerings a) underwritten offerings -describe
Pg-5
· shelf registration ➞ certain issuers can offer additional bonds
to the public without having to prepare a new and
separate offering
- may be used to cover multiple bond issues
b) best-efforts offering – investment bank/syndicate serve only
as a broker for a commission
c) auction – single price auction ➞ all the winning bidders pay the same
price and receive the same coupon rate (U.S. Treasuries)
- competitive + non-competitive bids
primary dealers accepts the rate determined

- final price = yield at which the issue clears
· multiple price auction ➞ each bidder pays their price
(Canada, Germany)
⇒ Primary bond markets/ LOS c, d

· Public Offerings -describe
Pg-6
d) Private Placements · non-underwritten
· unregistered
· one/few investors (pension fund, insurance)
- typically no active secondary markets
· low need for liquidity
⇒ Secondary bond markets/ · higher yield
investor investor Central Banks & large
investor dealer investor institutional investors
· exchange-listed ➞ very limited - very small retail presence
· OTC (over-the-counter) ➞ vast majority of bonds
- dealers act as market makers
· post bid - offer
↓ < 5 bps – very liquid
spread ➞ lower = more liquid 10-12 – reasonable
> 50 - illiquid
- no bid/offer = completely illiquid
18
LOS c, d
⇒ Secondary bond markets/
-describe
· Settlement – bonds passed to buyer and payment made Pg-7
· gov’t/quasi-gov’t ➞ cash or T +1
· corporate ➞ T + 2 or T + 3, maybe even T + 7
(some jurisdictions)
⇒ Sovereign bonds/
LOS e
- usually called Treasuries (even though they
-describe
have different names by country)
- name may also denote original maturity
e.g. U.S. Treasury - bill (T-Bill) <1 yr. (zero coupon)
- Note (T-Note) 1 yr. ≤ T-Note < 10 yrs.
coupon –
bearing - Bond (T-Bond) >10 yrs.
- most recently issued ➞ ‘on the run’ or benchmark issue
- most active in secondary market
- as sovereigns age, they trade less frequency
⇒ Sovereign bonds/ LOS e

· Credit Quality ➞ typically unsecured obligations -describe
Pg-8
➞ paid out of budget surplus
➞ deficits require ‘rolling over’ the principal + interest
- risk-free (theoretically) ➞ AAA or Aaa (only a few)
· local currency ➞ higher credit rating than foreign currency
- strong domestic savings base ➞ solid domestic demand
- liquid and freely traded currency ➞ strong international demand
· Types/ 1/ Fixed-rate bonds – by far the most common
2/ Floating-rate bonds – lower interest rate risk (i.e. price risk)
than fixed rate bonds
(Germany, Spain, US) (Japan, UK – never)
3/ Inflation-linked bonds – US ➞ TIPS (Treasury Inflation
- tied to CPI Protected Securities)
not a perfect proxy for inflation
19
⇒ Non-Sovereign/Quasi-government/Supranational/ LOS f
-describe
· Non-Sovereign: state, province, municipality
Pg-9
- not guaranteed by the national government
schools
- typically issued to finance public projects roads
hospitals
- ranging tax treatment depending on type & jurisdiction
- credit ratings differ widely, but generally high
- higher yield/lower price than comparable sovereigns
· Quasi-government: agency bonds
- rarely guaranteed by the sovereign (implied however)
- repaid from the cash flows of the entity
- typically high credit rating
· Supranational: supranational bonds ➞ highly rated
- some may be used as a benchmark for non-liquid
sovereign bonds
⇒ Corporate Debt/ LOS g

-describe
- companies have a choice: Debt or Equity
Pg-10
public private
· Private debt: 1/ Bi-lateral loans – single lender to single borrower
floating - rate usually bank typically

2/ Syndicated loans – a group of lenders to a single borrower
↓
can be packaged
not all will be banks
and securitized
- private debt can be customized to the borrowers need, can be interest
only or fully amortizing, usually more expensive than public debt
· Public debt: 1/ Commercial paper – short-term, unsecured
- working capital, seasonal needs, bridge financing
- largest issues are financial institutions
- maturity can range from overnight ➞ 1 yr. (3 mos. is typical)
20

-describe
· Public debt: 1/ Commercial paper ➞ Credit quality
Pg-11
prime paper ➞ IG
- maturing CP is usually met by ‘rolling over the paper’
introduces ‘rollover risk’

∴ credit rating agencies usually require issuers to secure
‘backup line of credit’ – referred to as a ‘liquidity enhancement’
- investors typically hold CP to maturity ∴ very low secondary market trading
- yield on CP > yield on same maturity sovereign debt
↓
credit risk
↓
illiquidity

-describe
· Public debt: 1/ Commercial paper U.S. vs. Eurocommercial
Pg-12
Paper
issued
internationally
also: smaller issue

sizes and less liquidity
e.g.: issue $50M @ 5% for 180 days
- interest = $1.25M - interest = $1.25M
- proceeds = $48.75M - proceeds = $50M
repay ➞ $50M repay ➞ $51.25M
2/ Corporate Notes and Bonds (range from 1 to 30 years, typically)
short < 5 yrs.
notes fixed or floating
5yr. ≤ medium < 12 yrs.
long >12 yrs. – bonds ➞ primarily fixed
21

· Public debt: 2/ Corporate Notes and Bonds -describe
quarterly inflation Pg-13
· Coupon payment structures fixed or
semi-annual market
floating
annual credit quality
- also ➞ zero coupon, deferred coupon, PIK bonds

· Principal repayment structures
- serial maturity – maturity dates are spread out over the bond’s life
- a stated # of bonds mature each year
- term maturity – principal all paid on one date (more credit risk)
· Asset or collateral backing – seniority ranking, secured vs. unsecured
· Contingency provisions – calls, puts, conversions
· Issuance, Trading, Settlement
underwritten OTC T + 2 or T + 3, longer for new issues
best efforts
LOS h
⇒ Structured Financial Instruments/
-describe
1/ Capital protected Instruments Pg-14
➞ buy a zero coupon bond + call options
equity
discount security on an index
↓ commodity
pays principal + option payoff
2/ Yield enhancement instruments e.g./ credit-linked note
- a bond that pays regular coupons but whose principal value depends on
specific credit events ratings downgrade
default of an underlying asset
· no credit event ➞ pays par
· credit event ➞ pays a recovery rate
Note: protects the issuer
- pays higher coupon in return, plus issued at a discount
22
⇒ Structured Financial Instruments/ LOS h

-describe
3/ Participation instruments – participate in the return of an
Pg-15
underlying asset
- offer exposure to a particular index or asset price
4/ Leveraged instruments e.g./ inverse floater
coupon rate = C – (L × R) - if reference rate (R) = 0
C is maxed out
-
leverage factor
e.g./ C = 9.5%
L = 3 9.5% - (3 × 2.5%) = 2% R ↓ 1.5%
Libor ➞ 2.5% ➞ 1% 9.5% - (3 × 1.0%) = 6.5% C ↑ 4.5%
- if L < 1, called a ‘deleveraged inverse floater’

L > 1 ➞ ‘leveraged inverse floater’
- often have floors (C is the cap)
⇒ Short-term funding alternatives for banks LOS i

1/ Retail Deposits – individual and commercial depositors -describe
Pg-16
· demand deposits ➞ pay no interest
· savings accounts ➞ pay interest but lack service levels of
demand deposits
· money market accounts ➞ money market rates of return
2/ Short-term wholesale funds
a) Reserve funds ➞ central bank funds
- banks place minimum level of funds with the central bank
- called reserves
- help ensure sufficient liquidity should depositors withdraw funds
- some banks have surplus reserves, other deficits
can lend extra reserves to other banks for

maturities of one day up to one year
overnight funds term funds
· interest is called the
central bank funds rate
23
⇒ Short-term funding alternatives for banks LOS i

-describe
2/ Short-term wholesale funds
Pg-17
b) Interbank funds ➞ loans/deposits between banks (unsecured)
➞ term: overnight to one year
rate ➞ interbank offered rate bank will typically quote 2 rates
➞ fixed rate ① rate at which it will lend
② rate at which it will accept a deposit
c) Large denomination negotiable CDs
allows depositor to sell CD in open market

before maturity
· usually issued in denominations of $1M or more (U.S.)
· typically traded among institutional investors
· have maturities < 1yr, pay interest at maturity
· yields are driven primarily by the credit risk of the issuing bank
⇒ Short-term funding alternatives for banks LOS j

3/ Repurchase and reverse repurchase agreements -describe
Pg-18
· repo ➞ the sale of a security with
funds
an agreement to buy it back at an Bank Bank
agreed on price at some future date A security B
repurchase price repurchase date
- basically a collateralized loan
- term = one day ➞ called an overnight repo
= longer ➞ term repo
· Interest rate ➞ repo date ➞ affected by
1/ risk associated with the collateral – higher quality = lower rate
2/ term of the repo – longer = higher
3/ physical delivery ➞ lower rate
4/ supply/demand of collateral ➞ the more scarce, the lower the
5/ other market rates rate (on special)
24
⇒ Short-term funding alternatives for banks LOS j

-describe
3/ Repurchase and reverse repurchase agreements
Pg-19
· interest is paid at the end of the repo term
· if the collateral pays interest, belongs to the borrower
- from the lender’s perspective ➞ called a reverse repo

often used to purchase
securities to cover a
· each side in a repo is exposed short position
to counterparty credit risk
- however the repo is structured in favour of the lender of cash
- the amount lent is lower than the collateral’s market value
- difference is called the ‘repo margin’ or haircut’
25
Introduction to Fixed-Income Valuation
a. calculate a bond’s price given a market discount rate;
b. identify the relationships among a bond’s price, coupon rate, maturity, and
market discount rate (yield-to-maturity);
c. define spot rates and calculate the price of a bond using spot rates;
d. describe and calculate the flat price, accrued interest, and the full price of a
bond;
e. describe matrix pricing;
f. calculate annual yield on a bond for varying compounding periods in a year;
g. calculate and interpret yield measures for fixed-rate bonds and floating-rate
notes;
h. calculate and interpret yield measures for money market instruments;
i. define and compare the spot curve, yield curve on coupon bonds, par curve,
and forward curve;
j. define forward rates and calculate spot rates from forward rates, forward
rates from spot rates, and the price of a bond using forward rates;
k. compare, calculate, and interpret yield spread measures.
26
Introduction to Fixed Income Valuation
⇒ Bond Prices/ LOS a, b

-calculate
a) using a single ‘market discount factor’ - a.k.a.:
-identify
- price of bond = PV (future cash flows) - required yield Pg-1
- required rate of return
e.g./ 5 yr., 4% annual bond, r = 6% ➞ r = market discount rate
𝟒 𝟒 𝟒 𝟒 𝟏𝟎𝟒 ➞ coupon + principal

+ + + +
𝟏. 𝟎𝟔 (𝟏. 𝟎𝟔)𝟐 (𝟏. 𝟎𝟔)𝟑 (𝟏. 𝟎𝟔)𝟒 (𝟏. 𝟎𝟔)𝟓 Note: bonds are
quoted as a percentage
= 𝟑. 𝟕𝟒 + 𝟑. 𝟓𝟔 + 𝟑. 𝟑𝟓𝟖 + 𝟑. 𝟏𝟔𝟖 + 𝟕𝟕. 𝟕𝟏𝟓 = 𝟗𝟏. 𝟓𝟕𝟓 of par (i.e. 100= par)
calculator: N = 5, FV = 100, PMT = 4, I/Y = 6, CPT PV

· if coupon rate = market rate - par bond
coupon rate < market rate - discount bond
coupon rate > market rate - premium bond
e.g./ 5 yr., 8% annual bond, r = 6% (N = 5, I/Y= 6, PMT= 8, FV= 100) CPT PV
= 108.425
⇒ Inverse relationship between bond prices and interest rates
(discount rates)

-calculate
a) using a single ‘market discount factor’
-identify
- semi-annual: 5 yr., 4% semi-annual bond r = 6%
Pg-2
(N = 10, I/Y = 3, PMT = 2, FV = 100) CPT PV = 91.46979
(vs. 91.575 for annual)
5 yr., 8% semi-annual bond, r = 6%
(N = 10, I/Y = 3, PMT = 4, FV = 100) CPT PV = 108.5302
(vs. 108.425 for annual)
- quarterly: (N = 20, I/Y = 1.5, PMT = 1, FV = 100) CPT PV = 91.4156
(N = 20, I/Y = 1.5, PMT = 2, FV = 100) CPT PV = 108.5843
Note: discount bonds PV ↓ as periodicity ↑
premium bonds PV ↑ as periodicity ↑
➞ Yield-to-Maturity - if PV is known (i.e. bond’s market price),
YTM can be calculated
- YTM is the IRR of the bond’s cash flows
27
⇒ Bond Prices/ investor holds the LOS a, b

➞ Yield-to-Maturity - assumes bond to maturity
-calculate
all cash flows are received -identify
on the specified dates
Pg-3
all coupon payments can be
e.g./ 4 yr., 5% annual bond @ 105 reinvested at the same rate
N = 4, PMT = 5, PV = -105, FV = 100
CPT I/Y = 3.634%
- if semi-annual
N = 8, PMT = 2.5, PV = -105, FV = 100
CPT I/Y = 1.82265 /semi-annual period × 2 = 3.645315%
- if quarterly
the greater the
N = 16, PMT = 1.25, PV = -105, FV = 100
periodicity, the
CPT I/Y = .912705 × 4 = 3.6508
higher the YTM
- if monthly
N = 48, PMT = 𝟓6𝟏𝟐, PV = -105, FV = 100
CPT I/Y = .30454 × 12 = 3.6545

-calculate
· 4 relationships 1/PV inversely related to I/Y
-identify
- bond price is inversely related to the market discount rate Pg-4
2/ given the same coupon & time to maturity: (inverse effect)
percentage 𝚫price when market rates increase is less than
price - called a ‘convexity effect’ when rates decrease
- in other words, bond prices increase by more

when rates drop than they drop in price when
market rate rates rise
3/ for the same time to maturity:

lower coupon bond is more price sensitive than a higher
coupon bond when rates change (coupon effect)
28

· 4 relationships 4/ for the same coupon rate: -calculate
longer-term bond is more price sensitive than a shorter-term bond -identify
Pg-5
(maturity effect)
- generally
4.95% ↑ as r ↓ 1%
4.60% ↓ as r ↑ 1%
convexity effect
all rise all drop
coupon effect
longer term bonds = higher price vol. lower coupon = higher note: maturity effect
price vol. does not hold for low
coupon, LT-bonds @
maturity effect a discount
LOS a, b
⇒ Bond Prices/ -calculate
-identify
Pg-6
pulled to par constant yield-price

over time trajectory
- bond prices change as

time passes even if
nothing else changes
10 yr., annual bonds, r = 8%
29
⇒ Bond Prices/ LOS c

-define
b) using multiple discount rates
-calculate
- spot rates ➞ rates that correspond to a bond’s cash flow dates Pg-7
∴ rather than using the same discount rate, each cash flow
is discounted by its associated spot rate
PV ➞ referred to as the bond’s yields-to-maturity on zero-

‘no arbitrage value’ coupon bonds maturity at
the date of each cash flow
e.g./ 𝟓 𝟓 𝟏𝟎𝟓
PV = + + = 𝟏𝟎𝟐. 𝟗𝟔 3 yr., 5% annual bond
(𝟏.𝟎𝟐) (𝟏.𝟎𝟑)𝟐 (𝟏.𝟎𝟒)𝟑
r(1) = 2% r(2) = 3% r(3) = 4%
(N = 3, PMT = 5, PV = -102.96, FV = 100) CPT I/Y = 3.935% (YTM)
(N = 3, PMT = 5, FV = 100, I/Y = 3.935) CPT PV = 102.96
⇒ Prices and Yields/ LOS d

- when a bond is between coupon dates, its price has 2 parts -calculate
① the flat price - PVflat Pg-8
sum = PVfull
② accrued interest - AI
dirty price
- dealers quote PV (a.k.a. - the clean price)
flat
- AI ➞ the proportional share of the next coupon payment belonging

= 𝐭6𝐓 where T = # of days between PMT to the seller
t = # of days since last PMT to the settlement date
- 2 conventions to count days:
𝐚𝐜𝐭𝐮𝐚𝐥6 𝟑𝟎6
𝐚𝐜𝐭𝐮𝐚𝐥 𝟑𝟔𝟎
- most common for gov’t bonds - typically corporate bonds
e.g./ May 15 & Nov. 15 ➞ coupon dates, settlement on June 27
𝟏𝟔 + 𝟐𝟕 𝟏𝟓 + 𝟐𝟕
= 𝟒𝟑6𝟏𝟖𝟒 = 𝟒𝟐6𝟏𝟖𝟎
𝟏𝟔 + 𝟑𝟎 + 𝟑𝟏 + 𝟑𝟏 𝟏𝟓 + 𝟑𝟎 + 𝟑𝟎 + 𝟑𝟎
+𝟑𝟎 + 𝟑𝟏 + 𝟏𝟓 +𝟑𝟎 + 𝟑𝟎 + 𝟏𝟓
30

-calculate
𝐏𝐌𝐓 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝐅𝐕
𝐏𝐕 𝐟𝐮𝐥𝐥 = + + ⋯+ Pg-9
𝐭 𝐭 𝐭2
(𝟏 + 𝐫)𝟏 / 2𝐓 (𝟏 + 𝐫)𝟐 / 2𝐓 (𝟏 + 𝐫)𝐍/ 𝐓
𝐏𝐌𝐓 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝐅𝐕 𝐭

= 8 + + ⋯+ : × (𝟏 + 𝐫) 2𝐓
(𝟏 + 𝐫) (𝟏 + 𝐫) 𝟐 (𝟏 + 𝐫) 𝐍
𝐭
= 𝐏𝐕 × (𝟏 + 𝐫) 2𝐓
this is not PVflat

e.g./ 5% semi, maturity date = Feb 15, 2024, act./act., settles May 14/2015
r = 4.8% Feb 15 Aug 15 Feb 15 Feb. 15 - Aug. 15
-
-
T = 181 T= 184 13 + 31 + 30 + 31
+ 30 + 31 + 15 = 181
𝐭 = 𝟏𝟑 + 𝟑𝟏 + 𝟑𝟎 + 𝟏𝟒 = 𝟖𝟖 N = 18 𝑷𝑽𝒇𝒖𝒍𝒍
= 𝟏𝟎𝟏. 𝟒𝟒𝟕𝟗 Aug. 15 - Feb. 15
PMT = 2.5 × (𝟏. 𝟎𝟐𝟒) 𝟖𝟖0𝟏𝟖𝟏 16 + 30 + 31 + 30
𝐭+ = 𝟖𝟖+
𝐓 𝟏𝟖𝟏 I/Y = 2.4 = 𝟏𝟎𝟐. 𝟔𝟐𝟒𝟑𝟐𝟑 + 31 + 31 + 15 = 184
FV = 100
𝐀𝐈 = 𝟖𝟖+𝟏𝟖𝟏 × 𝟐. 𝟓 CPT PV = 101.4479 𝐏𝐕 𝐟𝐥𝐚𝐭 = 𝟏𝟎𝟐. 𝟔𝟐𝟒𝟑𝟐𝟑
= 𝟏. 𝟐𝟏𝟓𝟒𝟕 − 𝟏. 𝟐𝟏𝟓𝟒𝟕
= 𝟏𝟎𝟏. 𝟒𝟎𝟖𝟖𝟓𝟑

e.g./ 6% corporate semi, settles Jun 18/2015 -describe
Pg-10
coupon dates ➞ Mar./Sept. 19 June 18
matures ➞ Sept. 19/2026 Mar 19 Sept 19 Mar 19
r = 6.2% *
-
Step #1. 30/360 day count

Step #3. Calculate PV
Sep 19/15
-
N = 23
T = 11 + 30 + 30 + 30+ 30 + 30 +19 = 180 2 × (16 - 26)
PMT = 3 11yrs.
t = 11 + 30 + 30 + 18 + 89
FV = 100 CPT PV = 98.372607
I/Y = 3.1
Step #2. AI
AI = 𝐭6𝐓 × 𝐏𝐌𝐓 Step #4. Calculate PVfull
𝟖𝟗
= 𝟖𝟗6𝟏𝟖𝟎 × 𝟑 = 𝟏. 𝟒𝟖𝟑̇ 𝐏𝐕 𝐟𝐮𝐥𝐥 = 𝟗𝟖. 𝟑𝟕𝟐𝟔𝟎𝟕 × (𝟏. 𝟎𝟑𝟏) 0𝟏𝟖𝟎
= 𝟗𝟗. 𝟖𝟔𝟖𝟖𝟎𝟓
Step #5. Calculate PVflat

𝐏𝐕 𝐟𝐥𝐚𝐭 = 𝟗𝟗. 𝟖𝟔𝟖𝟖𝟎𝟓 − 𝟏. 𝟒𝟖𝟑̇
= 𝟗𝟖. 𝟑𝟖𝟓𝟒𝟕𝟐
31
LOS e
⇒ Prices and Yields/
-describe
· Matrix Pricing - for fixed rate bonds without an active market, Pg-11
or not yet issued ➞ ∴ no market price to calculate YTM
- estimate PV and r based on prices of more frequently traded
comparable bonds (i.e. similar tenor, coupons, credit quality)
e.g./ 3yr., 4% semi corporate Step #1: find comparable bonds
Step #2: Calculate YTM for

2% 3% 4% 5% coupon each
98.50 102.25 3.8035%
2 (N = 4, PMT = 1.50, PV = -98.50,
term 3.786% 3.821%
FV = 100) CPT I/Y etc…
to 3
urity
mat Step #3: find avg. YTM/term
4
90.25 99.125 4.1885% Step #4: Interpolate the yield
5 4.181% 4.196%
LOS e
⇒ Prices and Yields/ -describe
e.g./ 3yr., 4% semi corporate Pg-12
2% 3% 4% 5% coupon
98.50 102.25 3.8035%
2
term 3.786% 3.821%
to 3 3yrs.
y 𝟑. 𝟖𝟎𝟑𝟓 + 𝟏0𝟑 (𝟒. 𝟏𝟖𝟖𝟓% − 𝟑. 𝟖𝟎𝟑𝟓%)
maturit
4 = 𝟑. 𝟗𝟑𝟏𝟖𝟑̇
90.25 99.125 4.1885%
5 4.181% 4.196% Step #5: Find PV
(N = 6, I/Y = 𝟑. 𝟗𝟑𝟏𝟖𝟑̇0𝟐 , 𝐅𝐕 = 𝟏𝟎𝟎,
Note: if the bond were floating instead: 𝐏𝐌𝐓 = 𝟐)
spread = 3.93183 - YTM on gov’t 3yr-semi CPT PV = 100.191
if gov’t YTM = 2.75%
spread = 118.183 bps
⇒ usually a different yield spread for each maturity & credit rating
term structure of credit spreads
32
⇒ Yield Measures/ LOS f, g, h

1/ Fixed rate bonds - yield measures typically are annualized -calculate
-interpret
and compounded (if > 1yr.)
Pg-13
e.g./ 5-yr. zero @ 80 Periodicity
annual 80 = 𝟏𝟎𝟎 6(𝟏 + 𝒓)𝟓 1➞ r = 0.04564
semi-annual 80 = 𝟏𝟎𝟎6(𝟏 2➞ r = 0.022565 × 2 = 0.04513
+ 𝒓)𝟏𝟎
quarterly 80 = 𝟏𝟎𝟎6(𝟏 4➞ r = 0.011220 × 4 = 0.04488
+ 𝒓)𝟐𝟎
monthly 80 = 𝟏𝟎𝟎6(𝟏 12➞ r = 0.003726 × 12 = 0.044712
+ 𝒓)𝟔𝟎
Note: 4.564% = 2.2565 compounded semi-annually
= 1.1220 compounded quarterly
= .3726 compounded monthly
the effective annual rate
· Semi-annual bond basis yield or semi-annual bond equivalent yield
= yield/semi-annual period × 2
2.2565 × 2 = 4.513%

1/ Fixed rate bonds -calculate
𝑨𝑷𝑹𝒎 𝒎 𝑨𝑷𝑹𝒏 𝒏 -interpret
➞ periodicity conversions: V𝟏 + [ = V𝟏 + [
𝒎 𝒏 Pg-14
e.g./ 3 yr., 5% semi @ 104
(N = 6, PMT = 2.5, PV = -104, FV = 100) CPT I/Y = .01791 (BEY)
(𝟏+ . 𝟎𝟑𝟓𝟖𝟐)𝟐 (𝟏 + 𝐀𝐏𝐑 𝟒 )𝟒 × 𝟐 = 𝟑. 𝟓𝟖𝟐%
quarterly equivalent = 𝟐
𝟐 𝟒 (𝟏. 𝟎𝟏𝟕𝟗𝟏) − 𝟏 = 𝟑. 𝟔𝟏𝟒𝟏
𝟏
_(𝟏. 𝟎𝟑𝟔𝟏𝟒𝟏) 2𝟒 − 𝟏` × 𝟒 = 𝟑. 𝟓𝟔𝟔% (EAY)
monthly equivalent (𝟏+ . 𝟎𝟑𝟓𝟖𝟐)𝟐 (𝟏 + 𝐀𝐏𝐑 𝟏𝟐 )𝟏𝟐

=
𝟐 𝟏𝟐
𝟏2
_(𝟏. 𝟎𝟑𝟔𝟏𝟒𝟏) 𝟏𝟐 − 𝟏` × 𝟏𝟐 = 𝟑. 𝟓𝟓𝟔%
3.582% ➞ 3.566% ➞ 3.556% compounding more frequently at a

(2) (4) (12) lower rate = compounding less
frequently at a higher rate
33
⇒ Yield Measures/ e.g./ 5 yr., 4.5% semi @ 98 LOS f, g, h

-calculate
1/ Fixed rate bonds
-interpret
① annual YTM? (N = 10, PMT = 2.25, PV = -98, FV = 100)
Pg-15
CPT I/Y = .0247826 × 2 = 4.95652%
(semi-annual bond basis)
𝟐
② convert to quarterly . 𝟎𝟒𝟗𝟓𝟔𝟓𝟐 𝑨𝑷𝑹𝟒 𝟒
V𝟏 + [ = V𝟏 + [
𝟐 𝟒
𝟏2
_(𝟏. 𝟎𝟓𝟎𝟏𝟕𝟗) 𝟒 − 𝟏` × 𝟒 = 𝑨𝑷𝑹𝟒 = 𝟒. 𝟗𝟐𝟔𝟏𝟖%
② convert to annual . 𝟎𝟒𝟗𝟓𝟔𝟓𝟐 𝟐 𝑨𝑷𝑹𝟏 𝟏

V𝟏 + [ = V𝟏 + [
𝟐 𝟏
[(𝟏. 𝟎𝟓𝟎𝟏𝟕𝟗) − 𝟏] × 𝟏 = 𝐀𝐏𝐑 𝟏 = 𝟓. 𝟎𝟏𝟕𝟗% - effective
annual
yield
· Street convention ➞ YTM that ignores the possibility that a PMT date
could be a weekend or holiday
· True yield ➞ takes any delayed PMT into consideration

-interpret
· government equivalent yield ➞ quoted for a corporate bond
Pg-16
➞ restates 𝟑𝟎6𝟑𝟔𝟎 to 𝐚𝐜𝐭𝐮𝐚𝐥6𝐚𝐜𝐭𝐮𝐚𝐥
➞ results in a more accurate ‘spread over
benchmark’ measure
· current yield (income or running yield) = ∑ 𝐜𝐨𝐮𝐩𝐨𝐧 𝐏𝐌𝐓𝐬 𝐟𝐨𝐫 𝐲𝐫.

𝐏𝐕 𝐟𝐥𝐚𝐭
· simple yield = 𝐏𝐌𝐓/𝐲𝐫 + 𝐒. 𝐋. 𝐚𝐦𝐨𝐫𝐭. 𝐨𝐟 𝐠𝐚𝐢𝐧/𝐥𝐨𝐬𝐬
𝐏𝐕 𝐟𝐥𝐚𝐭
➞ Embedded options/ 7 yr., 8% annual @ 105, callable after 4 years
yield measures: 102 in 4 years
yield to first call (FV = 102, PV = -105, PMT = 8, N = 4) 101 in 5 years
yield to second call (FV = 101, N = 5 100 in 6 years
yield to third call (FV = 100, N = 6
YTM (FV = 100, N = 7 call schedule
lowest = yield to worst
34

-interpret
➞ Embedded options/ pricing involves an option pricing
Pg-17
model + assumption about future interest rate volatility
Option-adjusted price = Option free bond - value of call option
or/ (+ value of put option)
used to calculate the
option-adjusted yield
2/ Floating rate bonds
- reference rate is usually a short-term money market
rate (i.e. Libor)
- determined at the beginning of the period, paid at the end
(in arrears)
Fixed-Coupon price
price Floating Coupon

2/ Floating rate bonds - common day count conventions -calculate
-interpret
➞ 𝐚𝐜𝐭.6𝐚𝐜𝐭. ➞ 𝐚𝐜𝐭.6𝟑𝟔𝟓 ➞ 𝟑𝟎6𝟑𝟔𝟎 ➞ 𝐚𝐜𝐭.6𝟑𝟔𝟎
Pg-18
· yield spread over the reference rate ➞ quoted margin ➞ credit related
· required margin ➞ spread required by investors to ➞ may even be
reflect changes in credit quality negative (sub-Libor)
- changes usually come from changes in the issuer’s credit risk
∴ FRN with quoted margin = 50 bps with no changes in credit
risk, required margin = 50bps
premium between PMT dates for a
PMT PMT
PV change in the reference
-
PV =100 PV =100 discount rate ➞ but PV pulled to

par as PMT date nears
QM - quoted margin · if QM = DM ➞ PV = 100 on reset date
DM - discount margin QM > DM ➞ PV > 100 and QM < DM ➞ PV < 100
35

-calculate
2/ Floating rate bonds
-interpret
Pg-19
(𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝑭𝑽 (𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝑭𝑽 (𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝑭𝑽
𝐦 𝐦 𝐦 + 𝑭𝑽
𝑷𝑽 = + + ⋯ +
𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌 𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌 𝟐 𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌 𝑵
n𝟏 + 𝐦 p 𝟏+ n p 𝟏+ n p
𝐦 𝐦
e.g./ 2 yr. FRN, Days 6-mos. Libor + 50bps, required spread = 40bps
1.25%
Index = .0125
QM = .005 N = 4
DM = .004 PMT = (𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝐅𝐕 (. 𝟎𝟏𝟐𝟓 + 𝟎. 𝟎𝟎𝟓) × 𝟏𝟎𝟎 . 𝟎𝟏𝟕𝟓
= = = . 𝟖𝟕𝟓
𝐦 𝟐 𝟐
I/Y = 𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌 . 𝟎𝟏𝟐𝟓+ . 𝟎𝟎𝟒 . 𝟎𝟏𝟔𝟓
= = = . 𝟖𝟐𝟓%
𝐦 𝟐 𝟐
FV = 100
CPT PV = 100.196 QM > DM ∴ PV > 100

2/ Floating rate bonds -calculate
e.g./ 5 yr. FRN, Days 3-mos. Libor, QM = 75bps, PV = 95.50 (DM = ?) -interpret
Pg-20
1.10%
N = 20, FV = 100, PV = -95.50, PMT 𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌 𝟏. 𝟖𝟓%
× 𝟒= × 𝟏𝟎𝟎 = . 𝟒𝟔𝟐𝟓
𝟒 𝟒
CPT I/Y = .7045% ➞ (.007045 × 4) - .0110 = DM
DM = 171.8 bps
e.g./ 4 yr. FRN, Days 3-mos. Euribor + 125 bps @ 98 (DM = ?)
2%
N = 16 PMT = 𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌 × 𝐟𝐯 = (. 𝟎𝟐+ . 𝟎𝟏𝟐𝟓) × 𝟏𝟎𝟎 = . 𝟖𝟏𝟐𝟓
FV = 100 𝐦 𝟒
PMT = .8125 CPT I/Y = .009478 ⇒ (.009478 × 4) - Index = DM

PV = -98
= .017912
or/ 179.12 bps
36

-calculate
3/ Money market instruments
-interpret
· annualized, but not compounded ⇒ instead Pg-21
rates of return are stated on a simple interest basis
either discount rates or add-on rates

(T-bills, CP, BA) (CDs, repos)
· Discount rates interest
𝐝𝐚𝐲𝐬 𝐲𝐫. 𝐅𝐕 − 𝐏𝐕 earned
𝐏𝐕 = 𝐅𝐕 × V𝟏 − × 𝐃𝐑[ ⇒ 𝐃𝐑 = V [V [
𝐲𝐫. 𝐝𝐚𝐲𝐬 𝐅𝐕
91-day T-bill, $10M, DR = 2.25%
FV, not PV
360 - day yr. periodicity
∴ DR will
𝟗𝟏
𝐏𝐕 = $𝟏𝟎𝐌 × q𝟏 − 6𝟑𝟔𝟎 × . 𝟎𝟐𝟐𝟓r understate the rate of
= $𝟗, 𝟗𝟒𝟑, 𝟏𝟐𝟓 return to the investor and
the cost of funds to the
borrower

3/ Money market instruments -calculate
𝑭𝑽 𝐲𝐫. 𝐅𝐕 − 𝐏𝐕 -interpret
· Add-on rates 𝐏𝐕 = ⇒ 𝐀𝐎𝐑 = V [V [
𝒅𝒂𝒚𝒔6 𝐝𝐚𝐲𝐬 𝐏𝐕 Pg-22
n𝟏 + 𝒚𝒓. × 𝑨𝑶𝑹p
e.g./ 180-day BA, AOR = 4.38, 365-day yr., $10M periodicity 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐞𝐚𝐫𝐧𝐞𝐝
𝐝𝐚𝐲𝐬6 𝐩𝐫𝐢𝐜𝐞 𝐩𝐚𝐢𝐝
𝐅𝐕 = 𝐏𝐕 n𝟏 + 𝐲𝐫. × 𝐀𝐎𝐑p
= $𝟏𝟎𝐌n 𝟏 + 𝟏𝟖𝟎6𝟑𝟔𝟓 × . 𝟎𝟒𝟑𝟖p = $𝟏𝟎, 𝟐𝟏𝟔, 𝟎𝟎𝟎
Note: 𝐅𝐕 = 𝐏𝐕(𝟏 + 𝐫)𝐧 ➞ compound interest
𝐝𝐚𝐲𝐬6
𝐅𝐕 = 𝐏𝐕 n𝟏 + 𝐲𝐫. × 𝐑p ➞ simple interest (money market yields)
➞ Sell after 45 days when AOR = 4.17%
𝟏𝟎, 𝟐𝟏𝟔, 𝟎𝟎𝟎 𝟑𝟔𝟓 𝟏𝟎. 𝟎𝟔𝟎𝟖𝟐𝟗 − 𝟏𝟎
𝐏𝐕 = = $𝟏𝟎, 𝟎𝟔𝟎, 𝟖𝟐𝟗 ⇒ implies AOR = V [
𝟏 + 𝟏𝟑𝟓6𝟑𝟔𝟓 × . 𝟎𝟒𝟏𝟕 𝟒𝟓 𝟏𝟎
= 𝟒. 𝟗𝟑𝟒%
37
⇒ Yield Measures/ ⇒ DR vs AOR LOS f, g, h

⇒ 360 vs 365 -calculate
3/ Money market instruments
-interpret
- convert all the AOR with 365 days to compare: Pg-23
e.g./ 90-day CP, DR = 5.76%, 360-day yr. vs. 90-day CD, AOR = 5.9%, 365d/yr.
𝐏𝐕 = 𝟏𝟎𝟎 × q𝟏 − 𝟗𝟎6𝟑𝟔𝟎 ×. 𝟎𝟓𝟕𝟔r = 𝟗𝟖. 𝟓𝟔
𝟏𝟎𝟎 − 𝟗𝟖. 𝟓𝟔
𝐀𝐃𝐑 = n𝟑𝟔𝟓6𝟗𝟎p V [ =. 𝟎𝟓𝟗𝟐𝟓 𝐯𝐬. 𝟓. 𝟗%
𝟗𝟖. 𝟓𝟔
BEY - bond equivalent yield ➞ AOR for 365d
- all 180 day A. 𝐏𝐕 = 𝟏𝟎𝟎 × q𝟏 − 𝟏𝟖𝟎6𝟑𝟔𝟎 ×. 𝟎𝟒𝟑𝟑r = 𝟗𝟕. 𝟖𝟑𝟓

A - DR = 4.33, 360d
𝟏𝟎𝟎 − 𝟗𝟕. 𝟖𝟑𝟓
B - DR = 4.36, 365d 𝐀𝐎𝐑 = n𝟑𝟔𝟓6𝟏𝟖𝟎p V [ = 𝟒. 𝟒𝟖𝟕%
𝟗𝟕. 𝟖𝟑𝟓
C - AOR = 4.35, 360d B. 𝐏𝐕 = 𝟏𝟎𝟎 × n𝟏 − 𝟏𝟖𝟎6
𝟑𝟔𝟓 ×. 𝟎𝟒𝟑𝟔p = 𝟗𝟕. 𝟖𝟒𝟗𝟖𝟔
D - AOR = 4.45, 365d 𝟏𝟎𝟎 − 𝟗𝟕. 𝟖𝟒𝟗𝟖𝟔
𝐀𝐎𝐑 = n𝟑𝟔𝟓6𝟏𝟖𝟎p V [ = 𝟒. 𝟒𝟓𝟔%
𝟗𝟕. 𝟖𝟒𝟗𝟖𝟔
ok!
C. 𝐅𝐕 = 𝟏𝟎𝟎 × q𝟏 − 𝟏𝟖𝟎6
𝟑𝟔𝟎 ×. 𝟎𝟒𝟑𝟓r = 𝟏𝟎𝟐. 𝟏𝟕𝟓
𝟏𝟎𝟐. 𝟏𝟕𝟓 − 𝟏𝟎𝟎
𝐀𝐎𝐑 = n𝟑𝟔𝟓6𝟏𝟖𝟎p V [ = 𝟒. 𝟒𝟏%
𝟏𝟎𝟎
⇒ Maturity structure of interest rates/ LOS i

yield -define
maturity structure -compare
or for bonds with the Pg-24
yield term structure same · currency · credit risk

curve · liquidity · tax status
time to · same coupon (reinvestment
risk held constant)
-
-
-
-
-
-
-
maturity
· government bond spot curve ➞ YTMs for zero-coupon bonds for a
(a.k.a. zero or strip curve) full range of maturities
upward sloping ➞ normal ➞ longer maturities have higher YTMs
downward sloping ➞ inverted
- no coupon ➞ no reinvestment risk, but/ most bonds have coupons
∴ need a term structure for coupon paying bonds, but/ older bonds may have
different tax/liquidity status ∴ use on-the-run bonds, but/ there is limited
data for the full range of maturities ∴ interpolate between dates
38
⇒ Maturity structure of interest rates/ LOS i

-define
- typically stated on -compare
a semi-annual bond basis Pg-25
- observed yields on recently issued ‘on-the-run’
coupon paying bonds
- 1 mos., 3 mos., 6mos. ➞ money market, all converted
-
-
-
-
-
-
- gov’t bond yield to BEY (semi-annual basis)
curve, coupon bonds ⇒ Par Curve = sequence of YTMs such that each
- bond is priced at par
- - par rates are derived from spot rates
-
spots 𝑷𝑴𝑻 + 𝟏𝟎𝟎
- 𝟏𝟎𝟎 = PMT = 5.263%
1 yr. - 5.263% 𝟏. 𝟎𝟓𝟐𝟔𝟑
- 𝑷𝑴𝑻 𝑷𝑴𝑻 + 𝟏𝟎𝟎
𝟏𝟎𝟎 = + PMT = 5.606
- 2 yr. - 5.616% 𝟏. 𝟎𝟓𝟐𝟔𝟑 (𝟏. 𝟎𝟓𝟔𝟏𝟔)𝟐
𝑷𝑴𝑻 𝑷𝑴𝑻 𝑷𝑴𝑻 + 𝟏𝟎𝟎 PMT
-
-
-
-
-
3 yr. - 6.359% 𝟏𝟎𝟎 = + +

𝟏. 𝟎𝟓𝟐𝟔𝟑 (𝟏. 𝟎𝟓𝟔𝟏𝟔) 𝟐 (𝟏. 𝟎𝟔𝟑𝟓𝟗) = 6.306
𝟑
4 yr. - 7.008%
etc…
⇒ Maturity structure of interest rates/ LOS j

· Forward curve ➞ based on forward rates -define
➞ agreed on today, received/paid in the future -compare
Pg-26
➞ quoted as ‘when, what’
e.g./ 2y5y ➞ an agreement on a rate, when ➞ in 2 years
f (2,5) more common what➞ a 5yr. rate
- implied forward rates are calculated from spot rates
3.65% f (3,1)
spots f (3,1)
3 yr. = 3.615%
-
4 yr. = 4.18%
4.18%
semi-annual . 𝟎𝟒𝟏𝟖 𝟖
. 𝟎𝟑𝟔𝟓 𝟔 𝒇(𝟑, 𝟏) 𝟐
bond basis V𝟏 + [ = V𝟏 + [ V𝟏 + [
𝟐 𝟐 𝟐
𝟏2
(𝟏. 𝟎𝟐𝟎𝟗)𝟖 𝟐
{| } − 𝟏~ = 𝒇(𝟑, 𝟏) = . 𝟎𝟐𝟖𝟖𝟗𝟏𝟒𝟓𝟐 × 𝟐
(𝟏. 𝟎𝟏𝟖𝟐𝟓)𝟔
= . 𝟎𝟓𝟕𝟕𝟖𝟐𝟗
39
LOS j
⇒ Maturity structure of interest rates/
-define
forward -compare
spot Pg-27
par par
spot
forward
- forward curve is a series of 1 yr. forward rates ➞ f(1,1), f(2,1), f(3,1), etc…
- forward rates are also referred to as break-even rate or no-arbitrage rates
· Pricing/ - using spots 𝑷𝑴𝑻 𝑷𝑴𝑻 𝑷𝑴𝑻 + 𝑭𝑽

+ +
- 3 yr. annual (𝟏 + 𝒓𝟏 ) (𝟏 + 𝒓𝟐 ) 𝟐 (𝟏 + 𝒓𝟑 )𝟑
- using forwards 𝑷𝑴𝑻 𝑷𝑴𝑻 𝑷𝑴𝑻 + 𝑭𝑽

+ +
(𝟏 + 𝒓𝟏 ) (𝟏 + 𝒓𝟏 )(𝟏 + 𝒇(𝟏, 𝟏)) (𝟏 + 𝒓𝟏 )(𝟏 + 𝒇(𝟏, 𝟏))(𝟏 + 𝒇(𝟐, 𝟏))
LOS k
⇒ Yield Spreads
-compare
-calculate
microeconomic -interpret
factors Pg-28
in bps
- issuer and the bond itself
can affect credit risk
as well
macroeconomic
factors
- general economic growth,
business cycle, fiscal and
monetary policy
varies across financial markets
➞ fixed rate bonds often use gov’t benchmark security (usually the most
recently issued ‘on the run’ security) ⇒ G-spread
➞ floating ➞ typically an interbank rate (e.g. Libor)
40
⇒ Yield Spreads LOS k

· U.S., UK, Japan ➞ spread over the benchmark for fixed rate -compare
-calculate
securities is the G-spread (risk free)
-interpret
· EUR ➞ benchmark is EUR interest swap rates ➞ I-Spread Pg-29
➞ spread over the standard swap rate in any currency
(risky)
fixed Libor swap rates
- for both the G-spread & I-spread, all cash flows are discounted at
the same rate
- z-spread ➞ a constant over a government spot curve (or swap curve)
zero volatility spread ➞ zero interest rate volatility

𝑷𝑽 = + +
(𝟏 + 𝐫𝟏 + 𝐳) (𝟏 + 𝐫𝟐 + 𝐳)𝟐 (𝟏 + 𝐫𝐧 + 𝐳)
option adjusted spread = z-spread - option value (in bps)
⇒ Yield Spreads/ LOS k

e.g./ 6% annual corporate, 2 yrs. to maturity @ 100.125 -compare
-calculate
2 yr., 4% annual gov’t bond @ 100.750
-interpret
r(1) = 2.10% r(2) = 3.635% Pg-30
1. G-spread: corporate bond YTM = 5.932%
(N = 2, PMT = 6, FV = 100, PV = -100.125)
gov’t bond YTM = 3.605
(N = 2, PMT = 4, FV = 100, PV = -100.175)
G-spread = 5.932% - 3.605% = 2.327% or 232.7 bps
2. Z-spread ➞ demonstrate that z-spread = 234.22 bps
𝟔 𝟏𝟎𝟔
+ = 𝟏𝟎𝟎. 𝟏𝟐𝟓
(𝟏+. 𝟎𝟐𝟏+. 𝟎𝟐𝟑𝟒𝟐𝟐) (𝟏+. 𝟎𝟑𝟔𝟑𝟓+. 𝟎𝟐𝟑𝟒𝟐𝟐)𝟐
41
Introduction to Asset-Backed Securities
a. explain benefits of securitization for economies and financial markets;
b. describe securitization, including the parties involved in the process and the
roles they play;
c. describe typical structures of securitizations, including credit tranching and

time tranching;
d. describe types and characteristics of residential mortgage loans that are

typically securitized;
e. describe types and characteristics of residential mortgage-backed securities,

including mortgage pass-through securities and collateralized mortgage
obligations, and explain the cash flows and risks for each type;
f. define prepayment risk and describe the prepayment risk of mortgage-

backed securities;
g. describe characteristics and risks of commercial mortgage-backed securities;
h. describe types and characteristics of non-mortgage asset-backed securities,

including the cash flows and risks of each type;
i. describe collateralized debt obligations, including their cash flows and risks.
42
Benefits of Securitization
Regulated Institutions Economy Financial Markets

· cost savings · greater credit · access to liquid
⇒ avoid capital availability investment &
maintenance reg. (banks are not payment streams
⇒ lower reserve limited by capital or otherwise unavailable
requirements risk concentration) · assets of SPV have
⇒ lower deposit · less concentration bankruptcy remoteness
insurance premiums risk - will carry
· additional source of higher credit rating
funding (lower cost) Investors than originator
⇒ SPV typically rated · higher risk-adjusted · wide choice of
higher than originator returns investment profiles
· increased loan · diversification
origination
Securitization
Physical Pg-1
Bond
asset
Investors
General
Debenture
claim
Auto
pool Asset-Backed
Home Investors
of Security
assets
Credit Card
Receivables
Student Loans
credit sensitive
43
Pg-2
buy a ⇒ originator
Customer Consumer Co.
product
⇒ may also be
flow, through
credit criteria makes a
(- fee) servicer
loan
(underwriting standards) cash · collecting
sells
· repossessing
loans
· liquidating
sell
securities Consumer Asset
Investor ⇒ special
(ABS) Trust (SPV)
interest purpose
+ cash vehicle
principal
Pg-3
Seller ⇒ originator of the loans (Consumer Co.)
Issuer/Trust ⇒ SPV (Consumer Asset Trust)
Servicer ⇒ Collections, etc. (Consumer Co.)
Others ⇒ Lawyers, Underwriters, Accountants, Rating Agencies, Trustees
Documents
Prospectus ⇒ ‘waterfall’ – priority and amounts of
payments
· service fees · admin. fees
· principal · interest
Purchase Agreement (Seller ➞ SPV)
Waterfall Structure
Servicing Agreement (Servicer & SPV)
44
Bonds Issued
Pg-1
Asset1 Senior tranche
Asset2 $80M
Libor + 60 bps
Asset3
SPV
Assetn Mezzanine tranche
$15M credit
Principal Libor + 250 bps tranching
$100M
Equity tranche
$5M
Libor + 1000 bps
⇒ redistributes credit risk
Pg-2
Assets Senior tranche (80%) – easy to sell
an ABS of an ABS
Mezzanine tranche (15%)
Senior tranche (65%)
- hard to sell
‘AAA’
Equity tranche (5%)
Mezzanine tranche (25%)
‘BB’
retained by originator
Equity tranche (10%)
or sold to hedge fund
‘C’
End Result: ⇒ the mezzanine tranche is

80% + 65% (15%) repackaged with other mezzanine
= 89.75% of asset tranches
pool is rated ‘AAA’ ‘AAA’ – easy to
sell
45
e.g./ Pg-3
Bond Class Par Value
A1 $ 40M
no n A2 $ 30M each would have different
o r di natio
su b A3 $ 20M terms to maturity and yields
A4 $ 10M
Sequential – pay
- each bond class receives periodic interest
- However: principal is repaid as follows:
- all principal to A1 until paid in full
- next is A2 until paid in full, etc…
· Redistributes prepayment risk ⇒ Called ‘Time Trancing’
or
‘Prepayment Trancing’
e.g./ Pg-4
Bond Class Par Value
A1 $ 35M
A2 $ 28M
AAA time
A3 $ 15M
+ credit tranching
A4 $ 12M
BB B (subordinate) $ 7M
C C (subordinate) $ 3M
$100M
Class (or tranche) A suffers no loss if defaults < $10M

- Class C absorbs losses first
referred to as ‘first piece loss’
46
SPV vs. Originator
Originator Co. ⇒ Balance Sheet

Loans stay on
Cash …
to · Originator Co’s
·
finance · Balance Sheet
sells bonds Loans
Versus
Originator Co.
SPV sells securities
Balance Sheet Loans ⇒ lower
Cash … ⇒ higher rating
·
·
·
- loans leave Originator Co’s
Loans
Balance Sheet (legally segregated)
Residential Mortgage Loans

Pg-1
Property maturity ∼ 30 yrs.
Conventional
Lender
Credit of Mortgage
Borrower + morg. insurance
perhaps
Loan-to-Value (LTV)
payments to Ratio = 𝐦𝐨𝐫𝐭𝐠𝐚𝐠𝐞
lender · principal 𝐩𝐫𝐨𝐩𝐞𝐫𝐭𝐲 𝐯𝐚𝐥𝐮𝐞
· interest
May include prepayments:
payments made in payment in full

excess of regular
payments partial payments ⇒ curtailments
47
· Prepayments ⇒ amount & timing of cash flows is not known Pg-2

with certainty (prepayment risk)
t = 0 5 yrs. t = 30
-
-
· if repaid in full or if
· lockout period prepayment > some certain amt.
· penalty period = penalty
(usually X months interest)
· Interest Rate Determination

· Fixed Rate, Level Payment, Fully Amortizing
ceiling
· Adjustable Rate Mortgages (ARMs)
floor
· Others: Initial Period Fixed Rate, then floating
: Teaser + Reset
: Convertible (Fixed ➞ Floating) or reverse
Amortization Schedule Pg-3

e.g. Fixed Rate, Level Payment, Fully Amortizing
⥥ ⥥ ⥥
6% equal payments last payment,
of interest + balance = $0
Principal
i.e. 30-yr., $200K @ 6%
Balance Principal Int. Amortized
N = 30 × 12 = 360 1 – $ 200,000 199.10 1000 $199,800.90
FV = 0 2 - 199,800.90 200.10 999 199,600.80
PV = 200,000 etc…
·
I/Y = .5% ·
·
CPT PMT = -1,199.10
$1,193.10 $ 1,193.10 6 0
48
i Principal Pg-4
Interest-service fee
par value of security holder

collateral gets net interest or
t = 0 30 yrs.
net coupon
· Rights of Lender in a Foreclosure
recourse non-recourse
- borrowers walk away
· all assets of the
borrower can be used
to make the lender
whole
Residential MBS
3 ‘credit guarantee’ sectors: MBS guaranteed by-

1) federal agency
- Government National Mortgage Association
(Ginnie Mae or GNMA)
2) government sponsored agencies
agency MBS
- Federal National Mortgage Association
(Fannie Mae or FNMA)
- Federal Home Loan Mortgage Corporation
(Freddie Mae or FHLMC)
3) private entities
non-agency MBS
- Banks
49
Mortgage Pass-Through Securities
mortgage rate – fees = pass through rate Pg-1

mortgage1
pool securities sold to investors
mortgagen pass through
principal
monthly payments +
interest
less servicing
principal and other fees
interest · To be included in the pool, each
prepayments mortgage must meet certain
penalties underwriting standards
· size
not all mortgages have
· docs required
the same rate conforming
· max LTV
· insured versus non-conforming
Not all mortgages have the same rate or time left Pg-2
e.g. Mortgage Balance Weight Rate Time Left
1 $125k 22.12% 7.5% 275
2 85k 15.04% 7.2% 260
3 175k 30.97% 7% 290
4 110k 19.47% 7.8% 285
5 70k 12.39% 6.9% 270
$565k 100% 7.28% 279 months
· Weighted-average coupon rate (WAC)

WAC = .2212(7.5%) + .1504(7.2%) + .3097(7%) + .1947(7.8%)
+ .1239(6.9%) = 7.28%
· Weighted-average maturity (WAM)
WAM = .2212(275) + .1504(260) + .3097(290) + .1947(285)
+ .1239(270) = 279 months
50
Measuring the Prepayment Rate (Speed) Pg-3

- Single Monthly Mortality Rate (SMM)
𝐩𝐫𝐞𝐩𝐚𝐲𝐦𝐞𝐧𝐭 𝐢𝐧 𝐦𝐨𝐧𝐭𝐡 𝐭
𝐒𝐌𝐌𝐭 =
𝐁𝐞𝐠𝐢𝐧𝐧𝐢𝐧𝐠 𝐦𝐨𝐧𝐭𝐡𝐥𝐲 𝐛𝐚𝐥𝐚𝐧𝐜𝐞 𝐟𝐨𝐫 𝐦𝐨𝐧𝐭𝐡 𝐭 − 𝐬𝐜𝐡𝐞𝐝𝐮𝐥𝐞𝐝
𝐩𝐫𝐢𝐧𝐜𝐢𝐩𝐚𝐥 𝐩𝐚𝐲𝐦𝐞𝐧𝐭𝐬 𝐟𝐨𝐫 𝐦𝐨𝐧𝐭𝐡 𝐭
e.g.
Beg. Bal33 = $358,326,766 𝟏, 𝟖𝟒𝟏, 𝟑𝟒𝟕
𝐒𝐌𝐌𝟑𝟑 =
Sched. Prin.33 297,825 𝟑𝟓𝟖, 𝟑𝟐𝟔, 𝟕𝟔𝟔 − 𝟐𝟗𝟕, 𝟖𝟐𝟓
Prepay33 1,841,347 = . 𝟓𝟏𝟒𝟑%
- based on historical observations ⇒ if SMM is assumed, the

of actual activity in month 33 PrepayAmt33 = SMM33 × (Beg.Bal33
– Sched.Prin33)
Conditional PrePayment Rate (CPR) Pg-4

⇒ the annualized SMM
CPR = 1 – (1 - SMM)12 1 – SMM ⇒ what is
NOT being prepaid
(1 – SMM)12 – for the
1 – what is NOT being
prepaid for the year year
= what is being prepaid for
the year
i.e. SMM = .005143 ∴ 6% of beg. yr. principal
CPR = 1 – (1 - .005143)12 will be prepaid during
= 1 – (.994857)12 the year over and
= .06 or 6% above regular principal payments
51
PSA Prepayment Rate referred to as 100% PSA Pg-5

or 100 PSA
Public
Securities
Association
6%
t=0 30
· assumes CPR of .2% in month 1 + .2% each additional month

up to 6% (30 months) ⇒ 6% thereafter
0 PSA = no prepayments
100 PSA = prepayments at the same speed as the benchmark
⇒ less than 100 = slower more than 100 = faster
Pg-6
Cash Flow Construction
if t < 30, then CPR = 6% q𝐭6𝟑𝟎r
t ≥ 30, then CPR = 6%
∴ for month 5, CPR = .06n𝟓6𝟑𝟎p = .01 or 1% annual
and CPR = 1 - (1 – SMM)12
(𝟏 − 𝐒𝐌𝐌)𝟏𝟐 = 𝟏 − 𝐂𝐏𝐑
𝟏
𝟏 − 𝐒𝐌𝐌 = (𝟏 − 𝐂𝐏𝐑) 2𝟏𝟐 = 𝟏 − (𝟏 − . 𝟎𝟏)
𝟏2
𝟏𝟐
𝟏
𝐒𝐌𝐌 = 𝟏 − (𝟏 − 𝐂𝐏𝐑) 2𝟏𝟐
− . 𝟎𝟎𝟎𝟖𝟑𝟕
for month 5, PSA = 165
Note: Applied to CPR, not SMM
CPR = .06 n𝟓6𝟑𝟎p = .01
165 PSA = 1.65(.01) = .0165
𝟏2 𝟏2
𝐒𝐌𝐌𝟓 = 𝟏 − (𝟏 −. 𝟎𝟏𝟓𝟓) 𝟏𝟐 = 𝟏 − ( . 𝟗𝟖𝟑𝟓) 𝟏𝟐 = . 𝟎𝟎𝟏𝟑𝟖𝟔
52
e.g. $400M, 7.5% Pass-through, WAC of 8.125%, WAM = 357 months Pg-7
100PSA 165PSA MH ➞ SPV ➞ SH
Months Months Beg. SMM PMT i Principal

from Seasoned Balance
now
1 4 $400,000,000 .000669 2,975,868 2.5M 267,535
2 5 399,464,995 .001106 N = 357
399,390,077 PV = 400M
FV = 0
I/Y = 𝟖. 𝟏𝟐𝟓6𝟏𝟐
Prepayment Total Principal Cash Flow 𝐂𝐏𝐑 = 𝟔%q𝟒6𝟑𝟎r = . 𝟖%

267,470 535,005 3,035,005 𝟏2
𝐒𝐌𝐌𝟒 = 𝟏 − (𝟏−. 𝟎𝟎𝟖) 𝟏𝟐
442,389 709,923 3,209,923
= . 𝟎𝟎𝟎𝟔𝟔𝟗
𝟏𝟔𝟓 𝐏𝐒𝐀 = 𝟏. 𝟔𝟓(. 𝟎𝟎𝟖) =. 𝟎𝟏𝟑𝟐
𝟏2
𝐒𝐌𝐌𝟒 = 𝟏 − (𝟏 − . 𝟎𝟏𝟑𝟐) 𝟏𝟐
= . 𝟎𝟎𝟏𝟏𝟎𝟔
Pg-8
Weighted Average Life
𝐓
𝐭 × 𝐏𝐫𝐨𝐣𝐞𝐜𝐭𝐞𝐝 𝐩𝐫𝐢𝐧𝐜𝐢𝐩𝐚𝐥 𝐫𝐞𝐜𝐢𝐞𝐯𝐞𝐝 @ 𝐭
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐋𝐢𝐟𝐞 = ˆ
𝟏𝟐 × 𝐓𝐨𝐭𝐚𝐥 𝐏𝐫𝐢𝐧𝐜𝐢𝐩𝐚𝐥
𝐢<𝟏
PSA Speed 50 100 165 200 300 400 500 600

Average Life 15.11 11.66 8.76 7.68 5.63 4.44 3.68 2.78
depends on prepayment assumption
= if mortgage rates drop, refinancing ↑, Prepayments ↑

∴ PSA Speed ↑, Average Life ↓
Called Contraction Risk
= if mortgage rates rise, refinancing ↓, Prepayments ↓
∴ PSA Speed ↓, Average Life ↑
Called Extension Risk
53
Pre-payment Risk Pg-9
Contraction Risk Extension Risk
decreasing rates arises increasing rates

from
· shorter average life results · longer average life

· greater cash flows in · minimum cash flows
price will not rise by Adverse price will fall at

as much as an Condition # 1 about the same rate
option-free bond as an option-free bond
lower re-investment Adverse lower cash flow for

of cash flow Condition # 2 re-investment
Collateralized Mortgage Obligation – CMO
Pool of Bond Class 1 Note: Prepayment Pg-1

Pass-through time risk is not eliminated,
Bond Class 2
Mortgage tranches only redistributed
Securities Bond Class 3
Collateral · different maturities
· different yields
Sequential-Pay Tranches
⇒ all Principal payments ⇒ Bond Class 1
⇒ when fully paid, then Bond Class 2
etc…
⇒ each Bond Class will get paid interest as per contractual agreement
54
$400M, 7.5% pass-through, WAC = 8.125%, WAM = 357 months Pg-2
Principal Paydown Window

A month 1 ➞ month 81
@ 165 PSA
B month 81 ➞ month 100
C month 100 ➞ month 178
D month 178 ➞ month 357
Original average life was 8.76 years @ 165 PSA

(of the collateral)
A ⇒ 3.42 average life shorter than average life of collateral

B ⇒ 7.54 - protection from extension risk
C ⇒ 11.58 (provided by C & D)
average life longer
D ⇒ 22.29
- protection from contraction risk
(provided by A & B)
Planned Amortization Class (PAC) & Support Tranches Pg-3

e.g. $400M, 7.5% pass-through, WAC = 8.125%, WAM = 357 months
- assumptions of an
upper & lower PSA Month @90 PSA @300 PSA Min. Pr. PMT
1 508,169 1,075,391 508,169
lower PSA – 90 2 569,843 1,279,412 569,843
3· 631,377 1,482,194 631,377
initial PAC collar/bond
· · ·
· · · ·
· · · ·
· · · ·
· · · ·
upper PSA – 300 211 949,482 213,309 213,309

213 946,083 209,409 209,409
· offers both contraction
& extension risk etc…
(two-sided prepayment support tranches get
protection) $ over min. Pr. PMT
55
Floating-rate tranches - collateral pays a fixed rate Pg-4
Solution: the CMO still gets a fixed -$ interest amount

➞ split into a floating & inverse floating portion
e.g. $96.5M @ 7.5% (Total int. = 95.5 × .075 = $7,237,500)

FL – 72, 375,000 (75%) 1-month Libor + 50 bps
IFL – 24,125,000 (25%) K – L × (1 – month Libor)
leverage 𝟕𝟓%6𝟐𝟓% = 𝟑
max int. occurs when Libor = 0%
FL ⇒ $361,875 So, Libor @ 3.75%
IFL ⇒ 6,875,625 = 28.5% (k) FL ⇒ 4.25%
24,125,000 IFL ⇒ 28.5 – 3(3.75) = 17.25%
𝟕, 𝟐𝟑𝟕, 𝟎𝟎𝟎
IFL floor = 0%, FL cap rate = = 𝟏𝟎% 9.5%
𝟕𝟐, 𝟑𝟕𝟓, 𝟎𝟎𝟎
Which tranche in a CMO structure is most suitable for: Pg-5
1. Investor concerned about contraction risk

sequential pay ⇒ last tranche
2. Investor looking for stable average life
PAC tranche slow
fast
3. Investor expecting rates to fall
Inverse floater
4. Investor ok with prepayment risk for high expected return
support tranche (of PAC)
56
Non-Agency Residential MBS
Agency ⇒ Prepayment risk – conforming mortgages Pg-1

- Explicit/Implicit Gov’t guarantee
Non-agency ⇒ Credit + Prepayment risk
- can include non-conforming loans
Cash flows ⇒ waterfall (credit tranching)
⇒ realized losses (priority of claims)
subordinate before senior
forecasting requires assumption about default rates as well
as prepayment rates
Credit Rating ⇒ usually require credit enhancements
Internal: senior/subordinate structure
i.e. A - senior $ 90M
B – sub. 7M – provides credit support for A
C – sub. 3M – provides credit support for B & A
Internal Credit Enhancements Cont. Pg-2

Reserve Funds
cash reserve funds ⇒ part of underwriting profits deposited in a fund
excess spread accounts ⇒ WAC = 8%, service = .25%
net passthrough = 7.25% 50 bps excess spread
Overcollateralization $105M ➞ SPV ➞ sells $100M
External Credit Enhancements
Financial guarantee by a third party
- typically monoline insurance co. - securities said
up to a specified amt. to be ‘wrapped’
i.e. $100M security issue, 5% guarantee
⇒ Covers first $5M in losses
57
Commercial MBS
Income pool of Pg-1

RMBS
producing commercial CMBS CMBS
assets mortgages
· apt. buildings
· office prop. non-recourse loans
· malls ∴ credit analysis involves
· industrial parks analysis of cash flows
etc…
on a loan-by-loan basis
debt-to-service coverage ratio loan-to-value ratio

𝐍𝐎𝐈 higher = better 𝐋𝐨𝐚𝐧
𝐝𝐞𝐛𝐭 𝐬𝐞𝐫𝐯𝐢𝐜𝐞 𝐀𝐩𝐩𝐫𝐚𝐢𝐬𝐞𝐝 𝐕𝐚𝐥𝐮𝐞
𝐜𝐨𝐬𝐭𝐬 can be
‘gamed’
Pg-2
⇒ if DSC & LTV ratios are not sufficient for a rating, subordination is used
⇒ rating agencies will require sequential retirement
∴ losses from defaults will be charged against lowest
priority tranche
(first loss piece, equity tranche, residual tranche)
Call Protection ⇒ at loan level
1) prepayment lockout 2 - 5 yrs.
2) defeasance ⇒ borrower purchases securities as
collateral to cover remaining principal balance + an
amount to substitute for what the yield would have been
(Defeasance premium)
58
Call Protection – con’t Pg-3

3) Prepayment penalty points i.e. 5-4-3-2-1
⇒ if borrower wishes to prepay in Year 1, must pay 105%
2 104%
etc…
4) Yield maintenance charges
a.k.a. – make whole charge ⇒ if refinanced to get lower rate,
borrower must make ‘yield’ whole
at structure level ⇒ Credit Tranching
Balloon Maturity Provisions – at end of term of loan
- borrower may not be able to - refinance
balloon risk
- lender will mostly likely - sell
extend the loan - pay ‘extension risk’
Auto-Loan Backed Securities
· typically issued by: - financial subsidiaries of auto manufactures Pg-1

- commercial banks often below
- independent finance companies market rates
Prime
high credit quality ⇒ secured Moody’s
⇒ begin to repay Pr. + i immediately < 3%
⇒ short-term in nature losses
⇒ originated by fin. subs. of auto manufacturers
Sub-Prime > 7%
- not as clear as home loans (near prime 3-7%
Cash Flows – Principal + interest + prepayments (amortizing loans)
sale & trade-ins

repossession and sale (business cycle related)
Prepayments loss or destruction (insurance)
early retirement
refinancing ⇒ minimal
59
Pg-2
⇒ all ALB Securities have some form of credit enhancement
A - senior
⇒ Credit tranching
B - mezzanine
C - equity (subordinate)
⇒ Reserve Account $5M on $100M
⇒ Overcollateralization $100M issued against $105M
⇒ Excess Interest - 8.5% - 1% = 7.5% but pays 6.75%
⇒
WAC – servicing .75% excess
spread
Credit-Card Receivable-Backed Securities
Visa/MC/Amex Pg-1
SPV Securities
Sears/Target
receivables interest (monthly, quarterly)

fixed or floating
· finance charges
cash flow (50% - uncapped)
· fee
to SPV
· principal
Note: Non-Amortizing finance charges
(18 mos. -10 yrs.) fees
lockout period
revolving period
principal
-
t = 0 t*
· any principal payments received are retained by the trustee and re-
invested in additional receivables to maintain the size of the pool
60
Pg-2
Payment Structure:
① Pass-through ⇒ principal paid to security holders on a pro-rata basis
② Controlled Amortization ⇒ PAC structure
③ Bullet payment ⇒ entire amount of FV
Gross Portfolio yield – charge offs = Net Portfolio yield
(finance charges + fees) (bad debts)
Early Amortization Triggers
⇒ 3 month average excess spread ≤ 0 - the AAA first
- no more reinvestment AA next
etc…
Collateralized Debt Obligations (CDO)

asset (collateral) Pg-1
· U.S. high yield corporates
manager
· structured financials (MBS/ABS)
· emerging market bonds senior
asset
· bank loans securities mezzanine
pool
· distressed debt equity
if only
if only loans (CLO)
bonds (CBO)
Asset Manager: buys/sells assets to generate cash flows
⇒ has restrictive covenants (cap. gains, interest)
⇒ ability to pay interest pmts. to tranches depends
on the performance of the assets
interest payments
cash flows come from maturing assets
sale of assets
61
fixed-rate Pg-2
bonds
SPV floating rate payments
some floating (one or more tranches)
rate loans
interest rate
swaps (fixed-for floating)
e.g. $100M CDO, fixed @ 11%, mgmt. fee = $640k
Senior $80M Libor + 70 bps 8% Libor

Collateral Swap
Mezzanine $10M 9% 6.4M
Equity $10M $11M
4.6M
In Out 640k ⇒ Mgmt. Fee
Libor + 4.6M Libor + 560k ⇒ Senior
900k ⇒ Mezzanine
2.5M ⇒ Equity assumes no
defaults
ramp-up period – mgr. buys assets Pg-3
t = 0 t = 1 yr. 5 yr. …. n
-
assets sold
securities retired
reinvestment period
(revolving) – proceeds are reinvested
capture CDO
spread
cash CDO remove assets synthetic CDO
from sponsor BS.
Arbitrage* Balance* Arbitrage* Balance*
Driven Sheet Driven Driven Sheet Driven
Cash Flow Market Cash Flow * motivation ⇒ active

CDO Value CDO CDO mgmt.
62
Understanding Fixed-Income Risk and Return
a. calculate and interpret the sources of return from investing in a fixed-rate

bond;
b. define, calculate, and interpret Macaulay, modified, and effective duration;
c. explain why effective duration is the most appropriate measure of interest

rate risk for bonds with embedded options;
d. define key rate duration and describe the use of key rate durations in
measuring the sensitivity of bonds to changes in the shape of benchmark
yield curve;
e. explain how a bond’s maturity, coupon, and yield level affect its interest rate
risk;
f. calculate the duration of a portfolio and explain the limitations of portfolio

duration;
g. calculate and interpret the money duration of a bond and price value of a
basis point (PVBP);
h. calculate and interpret approximate convexity and distinguish between

approximate and effective convexity;
i. estimate the percentage price change of a bond for a specified change in

yield, given the bond’s approximate duration and convexity;
j. describe how the term structure of yield volatility affects the interest rate
risk of a bond;
k. describe the relationships among a bond’s holding period return, its duration,
and the investment horizon;
l. explain how changes in credit spread and liquidity affect yield-to-maturity of

a bond and how duration and convexity can be used to estimate the price
effect of the changes.
63
Sources of Return -Fixed Rate Bond
credit ① Coupon payments + principal (on scheduled dates) Pg-1

risk
② Reinvestment of coupon
t
interes ③ Capital gain/loss
rate
ri s k
Example: 10-year, 8% annual @ 85.503075, YTM = 10.40%
𝟖 𝟖 𝟏𝟎𝟖
(PV) 𝟖𝟓. 𝟓𝟎𝟑𝟎𝟕𝟓 = + + ⋯+ r = 0.104
(𝟏 + 𝐫) (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)𝟏𝟎
8 8(1.104)9
Total coupons $80
Interest-on
-
t = 0 t = 1 t = 2 t = 10 interest 49.970678
Principal 100
8(1.104)8
229.970678
8
85.503075 = (1.104)10
129.970678
Pg-2
YTM assumes 1) held to maturity
2) No default
3) Coupons re-invested at same rate of interest
Now assume same bond ⇒ But sold after 4-years
-
t = 0 t = 4 t = 10
FV (coupons) = 8(1.104)3 + 8(1.104)2 + 8(1.104) + 8 = 37.347111
PV of 6-year, 8% annual with YTM = 10.40% = 89.668770

𝟏𝟐𝟕. 𝟎𝟏𝟓𝟖𝟖𝟏
Total Return = = 85.503075 r = 10.40%
(𝟏 + 𝐫)𝟒
· horizon yield
Assumes ① coupons re-invested at 10.40%
② Bond is sold on the constant-yield price curve
64
Pg-3
100 -
carrying value ⇒ purchase price + amortized amt.

Capital gain of the bond (85.503075) of the discount
Capital loss OR
89.668770 “ “
“ “ premium
80 -
t
-
-
5 10
Now: Assume interest rates rise 100 bps (10.40% ⇒ 11.40%)
9 yrs.
8 11.4%
-
-
.
t = 0 t = 1 t = 10 .
.
.
(85.503075) .
.
136.380195 r = 10.7%
100
𝟐𝟑𝟔. 𝟑𝟖𝟎𝟏𝟗𝟓
𝟖𝟓. 𝟓𝟎𝟑𝟎𝟕𝟓 −
(𝟏 + 𝐫)𝟏𝟎
Now: Assume interest rates rise 100 bps (10.40% ⇒ 11.40%) Pg-4
Sold after 4 years FV of coupons at t = 4 37.899724 (+)
PV of 6-yr. bond at t = 4 85.780408 (-)
𝟏𝟐𝟑. 𝟔𝟖𝟎𝟏𝟑𝟐
𝟖𝟓. 𝟓𝟎𝟑𝟎𝟕𝟓 = = 𝟎. 𝟎𝟗𝟔𝟕
(𝟏 + 𝐫)𝟒
89.668770 – 85.780408 = 3.888362
Capital loss
Now: Assume interest rates fall 100 bps (10.40% ⇒ 9.40%)

Buy-and-Hold Sold after 4-years
r = 10.10% r = 0.1117
· lower re-investment · lower re-investment of coupon

of coupon · Capital gain on sale of bond
interest rate risk interest rate risk
65
Interest Rate Risk
Duration ⇒ measures the sensitivity of the bond’s full price to changes in Pg-1
the bond’s own yield or, more generally, changes in the
benchmark rate
- assumes all other variables are held constant
➞
⇒ represents approx. amount of time a bond would have to be
PV held for the market discount rate to be realized
e.g. 10-yr. 8% annual @ 85.503075, YTM = 10.4%
Duration = 7.0029 ⇒ if rates ↑ (+)𝐫𝐞𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐨𝐟
r ➞ 𝐜𝐨𝐮𝐩𝐨𝐧
(−) 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐥𝐨𝐬𝐬
= ∅ 𝐢𝐟 𝐡𝐞𝐥𝐝 𝐟𝐨𝐫 𝟕. 𝟎𝟎𝟐𝟗 𝐲𝐫𝐬.
- several types of bond duration/ Pg-2
yield duration curve duration

- sensitivity of price to - sensitivity of price to
own YTM benchmark yield
gov’t yield curve

e.g./ Macauley spot curve
modified forward curve
➞
money par curve (often used)
price value for a (PVBP) - used with complex bonds
basis point and also with financial
assets/liabilities that
will require an have int. rate risk but are
option pricing model not bonds
e.g./ effective
66
Macaulay Duration/ Pg-3
q𝟏 − 𝐭6𝐓r 𝐏𝐌𝐓 q𝟐 − 𝐭6𝐓r 𝐏𝐌𝐓 q𝐍 − 𝐭6𝐓r (𝐏𝐌𝐓 + 𝐅𝐕)

𝐭 + 𝐭 + ⋯+ 𝐭
(𝟏 + 𝐫)𝟏/ 2𝐓 (𝟏 + 𝐫)𝟐/ 2𝐓 (𝟏 + 𝐫)𝐍/ 2𝐓
𝐭 + ➞
𝐭 + ⋯ + 𝐭
(𝟏 + 𝐫)𝟏/ 2𝐓 (𝟏 + 𝐫)𝟐/ 2𝐓 (𝟏 + 𝐫)𝐍/ 2𝐓
closed-form/
𝟏+𝐫 𝟏 + 𝐫 + [𝐍 × (𝐜 − 𝐫)]
Ž − • − q𝐭6𝐓r c = coupon
𝐫 𝐜 × [(𝟏 + 𝐫)𝐍 − 𝟏] + 𝐫
annualized Pg-4
modified duration/ e.g./ (AnnModDur)
𝐌𝐚𝐜𝐃𝐮𝐫 𝟕. 𝟎𝟎𝟐𝟗
𝐌𝐨𝐝𝐃𝐮𝐫 = = 𝟔. 𝟑𝟒𝟑𝟐
𝟏+𝐫 𝟏. 𝟏𝟎𝟒
interpretation/ - provides an estimate of the percentage
price change for a bond given a change in its YTM (linear estimate)
➞
%𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 ≈ − 𝐀𝐧𝐧𝐌𝐨𝐝𝐃𝐮𝐫 × 𝚫𝐲𝐢𝐞𝐥𝐝 annual yield
e.g./ if r = 11.4% instead of 10.4%
%𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 ≈ −𝟔. 𝟑𝟒𝟑𝟐 × . 𝟎𝟏𝟎𝟎 = − 𝟔. 𝟑𝟒𝟑𝟐% requires
a
r = 9.4% instead of 10.4%
convexity
%𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 ≈ −𝟔. 𝟑𝟒𝟑𝟐 × 𝟎. 𝟎𝟏𝟎𝟎 = − 𝟔. 𝟑𝟒𝟑𝟐% adjustment
67
𝐌𝐚𝐜𝐃𝐮𝐫 Pg-5
So…if MacDur is known, 𝐌𝐨𝐝𝐃𝐮𝐫 =
(𝟏 + 𝐫)
- if MacDur is not known, we can approximate ModDur
(𝐏𝐕/ ) − (𝐏𝐕= ) 𝐫𝐢𝐬𝐞
𝐀𝐩𝐩𝐫𝐨𝐱. 𝐌𝐨𝐝𝐃𝐮𝐫 = =
𝟐 × 𝚫𝐲𝐢𝐞𝐥𝐝 × 𝐏𝐕𝟎 𝐫𝐮𝐧
PV
Price-Yield Curve for small 𝚫yield
PV-
➞ ApproxModDur
PV0 =
AnnModDur
PVt -
ApproxMacDur
line tangent to
Price-Yield Curve = ApproxModDur
YTM
r + × (1+r)
e.g./ 10-year, 8% annual @ 85.503075, YTM = 10.4% Pg-6
(𝐏𝐕/ ) − (𝐏𝐕= ) 𝟖𝟔. 𝟖𝟕𝟑𝟖𝟖 − 𝟖𝟒. 𝟏𝟔𝟏𝟖𝟏𝟗

𝐀𝐩𝐩𝐫𝐨𝐱𝐌𝐨𝐝𝐃𝐮𝐫 = =
𝟐 × 𝚫𝐲𝐢𝐞𝐥𝐝 × 𝐏𝐕𝟎 𝟐 × (. 𝟎𝟎𝟐𝟓) × 𝟖𝟓. 𝟓𝟎𝟑𝟎𝟕𝟓
𝟐. 𝟕𝟏𝟐𝟎𝟔𝟐𝟑
up 25 bps down 25 bps =
. 𝟒𝟐𝟕𝟓𝟏𝟓
10 N 10
8 PMT 8 ➞ = 𝟔. 𝟑𝟒𝟑𝟕𝟕
100 FV 100 vs.
10.65 I/Y 10.15
84.161819 + PV - 86.87388 6.3432
∴ if rates ↑ 50bps
%𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 ≈ −𝐀𝐩𝐩𝐫𝐨𝐱𝐌𝐨𝐝𝐃𝐮𝐫 × 𝚫𝐲𝐢𝐞𝐥𝐝 = − 𝟔. 𝟑𝟒𝟑𝟕𝟕 × . 𝟎𝟎𝟓 = −𝟑. 𝟏𝟕%
68
Effective Duration/ (𝐏𝐕/ ) − (𝐏𝐕= ) Pg-7

𝐄𝐟𝐟𝐃𝐮𝐫 =
𝟐 × 𝚫𝐜𝐮𝐫𝐯𝐞 × 𝐏𝐕𝟎
- used for complex bonds with embedded options
Value of the embedded - requires on option

PV- Call option pricing model for
➞ (PV-)
PV0
(thus, Macaulay &
Non-Callable Bond
PVt modified duration are
useless)
Callable Bond
- r +
Effective Duration/ Pg-8

(𝐏𝐕/ ) − (𝐏𝐕= )
- for a callable bond/ · may be called if
credit
decreases 𝚫credit duration
spread ➞
or
benchmark
decreases 𝚫curve duration
yield
- also used for FRNs, MBS, DBPP (retirement obligations)
homeowner’s have a
call option
69
Q: Does a 𝚫curve = 𝚫yield? Pg-9

i.e./ EffDur = ModDur on a fixed-rate, non-callable bond?
𝚫curve is
based on
ModDur vs. EffDur
spot curve par curve
- when par curve is shifted, spot curve is

also shifted, but not in a parallel
manner
- flatter the par curve

- shorter the bond EffDur ≈ ModDur
- close price is to par
Key Rate Duration

LOS d
EffDur ⇒ assumes a parallel shift in
-define
the yield curve -describe
- if the yield curve shifts in a non-parallel manner, Pg-1
a portfolio’s EffDur cannot be used to estimate %𝚫𝐏𝐨𝐫𝐭. 𝐕𝐚𝐥𝐮𝐞
r
2 < 𝚫𝐜𝐮𝐫𝐯𝐞 𝐱 𝑷𝒐
· key-rate duration is the duration
at a specific maturity on the yield
➞
curve
∴ for a non-parallel shift in
r - the yield curve, key-rate
duration must be used to
bps 𝚫𝐜𝐮𝐫𝐯𝐞
r - estimate %𝚫𝐏𝐨𝐫𝐭. 𝐕𝐚𝐥𝐮𝐞
70
-
-
-
-
-
-
-
-
-
-
-
-
-
Maturity
r LOS d
-define
-describe
Pg-2
r -
r - Key Rate Duration

➞ (𝐏𝐕/ ) − (𝐏𝐕= )
=
𝟐 × 𝚫𝐫𝐚𝐭𝐞 × 𝐏𝟎
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
Maturity
𝚫yield
11 maturities 𝚫curve
𝟏𝟏
- a key rate duration is
ˆ=
calculated for each = EffDur
𝐢<𝟏
EffDur ∑=𝟏
maturity
𝐌𝐚𝐭 𝟏 𝐌𝐚𝐭 𝟐 𝐌𝐚𝐭 𝟏𝟏

%𝚫𝐏𝐨𝐫𝐭𝐕𝐚𝐥𝐮𝐞 = 𝐊𝐞𝐲𝐑𝐚𝐭𝐞𝐃𝐮𝐫𝟏 V [ + 𝐊𝐑𝐃𝟐 V [ + ⋯ + 𝐊𝐑𝐃𝟏𝟏 V [
𝐏𝐨𝐫𝐭. 𝐕. 𝐏𝐨𝐫𝐭. 𝐕. 𝐏𝐨𝐫𝐭𝐕.
Pg-3
𝐌𝐚𝐜𝐃𝐮𝐫 𝟏+𝐫 𝟏 + 𝐫 + [𝐍 − (𝐂𝐜 − 𝐫)]
(𝐃𝐦𝐚𝐜 ) = Ž − ’ “• − q𝐭6𝐓r Dmac = f (c, r, N, t)
𝐫 𝐜 × [(𝟏 + 𝐫)𝐍 − 𝟏] + 𝐫
① 𝚫t ⇒ c, r, N - constant zero coupon

D bond
𝟏=𝐫
Discount
(N – 1) each date 𝐫 Perpetuity
Premium
➞
45°
time – to time – to
-
-
coupon
-
-
-
maturity maturity
payment
I𝐭0𝐓 = 𝟎K
dates 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝐅𝐕 D↑
⇒ low coupon bond ⇒ higher D (𝟏 + 𝐫)
∴ more interest rate risk
⇒ low YTM = higher D ➞ larger weights
71
Example/ Pg-4
C PV YTM
A 10 yr. 58.075279
-
annual
B 20 yr. 10% 51.304203 20%
C 30 yr. 50.210636
-
⇒ +/- 1 bps
A B C
PV0 = 58.075279 PV0 = 51.304203
5.063
PVt = N = 10 PMT = 10 ➞ PVt = N = 20 PMT = 10
FV = 100 I/Y = 20.01 FV = 100 I/Y = 20.01
CPT PV = 58.047598 CPT PV = 51.277694
PV_ = N = 10 PMT = 10 PV_ = N = 20 PMT = 10
FV = 100 I/Y = 19.99 FV = 100 I/Y = 19.99
CPT PV = 58.102981 CPT PV = 51.330739
𝟓𝟖. 𝟏𝟎𝟐𝟗𝟖𝟏 − 𝟓𝟖. 𝟎𝟒𝟕𝟓𝟗𝟖

𝐀𝐩𝐩𝐫𝐨𝐱. 𝐌𝐨𝐝. 𝐃𝐮𝐫. = Approx.Mod.Dur. = 5.169
𝟐 × . 𝟎𝟎𝟎𝟏 × 𝟓𝟖. 𝟎𝟕𝟓𝟐𝟕𝟗
= 𝟒. 𝟕𝟔𝟖
PV Pg-5
𝐌𝐚𝐜𝐃𝐮𝐫
PV_ = 𝐌𝐨𝐝𝐃𝐮𝐫
(𝟏 + 𝐫)
～option-pricing
model
𝐀𝐩𝐩𝐫𝐨𝐱𝐌𝐨𝐝𝐃𝐮𝐫
(𝐏𝐕/ ) − (𝐏𝐕= )
PV_
𝟐 × 𝚫𝐲𝐢𝐞𝐥𝐝 × 𝐏𝐕𝟎
PV ➞
Non-Callable Bond
𝐄𝐟𝐟𝐃𝐮𝐫
= (𝐏𝐕/ ) − (𝐏𝐕= )
r 𝟐 × 𝚫𝐜𝐮𝐫𝐯𝐞 × 𝐏𝐕𝟎
Benchmark
Yield
72
Duration of a Bond Portfolio
2 ways to calculate: Pg-1

1) weighted average of time to receipt of the aggregate
cash flows
2) weighted average of the individual bond durations in
the portfolio
𝐁𝐕𝟏 𝐁𝐕 𝐁𝐕
𝐀𝐯𝐠. 𝐌𝐨𝐝𝐃𝐮𝐫 = 𝐌𝐨𝐝𝐃𝐮𝐫 | } + 𝐌𝐨𝐝𝐃𝐮𝐫
➞ | 𝟐 } + ⋯ + 𝐌𝐨𝐝𝐃𝐮𝐫 | 𝐧 }
𝐁𝐩 𝐁𝐩 𝐁𝐩
𝐧
such that ˆ 𝐁𝐕𝐢 = 𝐁𝐩
𝐢<𝟏
𝐌𝐚𝐜𝐃𝐮𝐫 where m = periodicity

and 𝐌𝐨𝐝𝐃𝐮𝐫 =
𝐘𝐓𝐌
𝟏+ 𝐦
Pg-2
e.g. A B C
𝐁𝐕
$25M $25M $50M 𝐌𝐨𝐝𝐃𝐮𝐫 | 𝐢 } + ⋯ 𝐞𝐭𝐜
𝐁𝐩
Coupon 9% 11% 8%
TTM 6yrs. 8yrs. 12yrs. 𝐌𝐚𝐜𝐃𝐮𝐫
YTM 9.1% 9.38% 9.62% 𝐘𝐓𝐌
𝟏+ 𝐦
MV $24,886,343 $27,243,887 $44,306,787
MacDur 4.761 5.633 7.652
Bp = $96,437,017 Avg.ModDur = 𝟒. 𝟕𝟔𝟏 𝟐𝟒, 𝟖𝟖𝟔, 𝟑𝟒𝟑

➞ ” ×
𝟎. 𝟎𝟗𝟏 𝟗𝟔, 𝟒𝟑𝟕, 𝟎𝟏𝟕
•+
semi-annual coupons 𝟏+ 𝟐
MacDur – annualized
so…if YTM ↑ 20bps 𝟓. 𝟔𝟑𝟑 𝟐𝟕, 𝟐𝟒𝟑, 𝟖𝟖𝟕

” × •+
𝟎. 𝟎𝟗𝟑𝟖 𝟗𝟔, 𝟒𝟑𝟕, 𝟎𝟏𝟕
6.0495 × 0.002 = 0.0121 𝟏+ 𝟐
or 1.21% decline
𝟕. 𝟔𝟓𝟐 𝟒𝟒, 𝟑𝟎𝟔, 𝟕𝟖𝟕
” × • = 𝟔. 𝟎𝟒𝟗𝟓
𝟎. 𝟎𝟗𝟔𝟐 𝟗𝟔, 𝟒𝟑𝟕, 𝟎𝟏𝟕
𝟏+ 𝟐
73
Pg-3
Money Duration ⇒ measure of price change in
currency terms
Money Dur. = Ann.ModDur × PV full
per 100 of versus actual

𝚫PVfull ≈ - MoneyDur × 𝚫yield par value face value
e.g. PVfull = 100.940243
∴ if YTM ↑ 100 bps
Ann.ModDur = 6.1268
𝚫PVfull = - (618.44178 × 0.01)
MoneyDur. = 6.1268 (100.940243)
= 618.44178 ➞= 6.184417 ≈ 6.1268%
Price Value of a Basis Point (PVBP)

𝚫PVfull for 𝚫1bp
(𝐏𝐕/ ) − (𝐏𝐕= ) a.k.a. PVO1
𝐏𝐕𝐁𝐏 =
𝟐 DVO 1 (U.S.)
or
basis point value BVP = MoneyDur × 0.0001
Pg-4
e.g. FV = $10M 1. Calculate money duration
coupon = 4.5% Money Dur. = Ann.ModDur ×PVfull
PVfull = 99.65
𝟐. 𝟒𝟗𝟖𝟖
YTM = 5.2617% =” • × 𝟗𝟗. 𝟔𝟓 = 𝟐𝟒𝟐. 𝟔𝟐
𝟎. 𝟎𝟓𝟐𝟔𝟏𝟕
MacDur = 2.4988 𝟏+ 𝟐
➞
2. Calculate 𝚫PV for 1bp ↑ in YTM
full
BPV = MoneyDur. × 0.0001
= 242.62 × 0.0001 = 0.024262 /100 of par value

$𝟏𝟎𝐌
∴ × 0.024262 = $2,426.20 drop in MV for 𝚫1bp.
𝟏𝟎𝟎
74
Price Pg-5
𝚫PV due to duration – primary effect
𝚫PV due to convexity – secondary effect ⇒ for
large 𝚫bps.
Convexity
YTM Adjustment
𝟏
%𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 ≈ (−𝐀𝐧𝐧. 𝐌𝐨𝐝𝐃𝐮𝐫 × 𝚫𝐲𝐢𝐞𝐥𝐝) 𝟐
➞ 𝟐 𝐀𝐧𝐧. 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 × (𝚫𝐲𝐢𝐞𝐥𝐝) :
+ 8
due to duration due to convexity

first-order effect second-order effect
if 𝚫bp+ (neg.) + (pos.)
if 𝚫bp- (pos.) + (pos.)
Closed Form - –𝐍 − q𝐭6𝐓r— × –𝐍 + 𝟏 − q𝐭6𝐓r— Approx.Con. = (𝐏𝐕/ ) + (𝐏𝐕= ) − (𝟐𝐏𝐕𝟎 )

(𝟏 + 𝐫)𝟐 𝐏𝐕𝟎 (𝚫𝐲𝐢𝐞𝐥𝐝)𝟐
𝐦𝟐
Pg-6
e.g. 7.25% annual, YTM = 7.44% Recall: pg. 410, R54, Eq. (6)
Maturity Apr. 4/2029 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝐅𝐕 𝐭
Settles Jun. 27/2014 𝐏𝐕 𝐟𝐮𝐥𝐥 = 8 + ⋯+ : × (𝟏 + 𝐫) 2𝐓
𝟏+𝐫 (𝟏 + 𝐫)𝐧
𝐭6 = 𝟖𝟑6
𝐓 𝟑𝟔𝟎
1. Calculate PVfull: PMT = 7.25, r = 0.0744, 𝐭6𝐓 = 𝟖𝟑6𝟑𝟔𝟎, PV0 = 99.95678

2. Calcuate Approx.ModDur & Approx.Con. for 𝚫1bp ⇒ 0.0001
PV+ ⇒ 1.0744 ➞ 1.0745 = ➞

99.869964
PV- ⇒ 1.0744 ➞ 1.0743 = 100.043703
−(𝐏𝐕3 ) − (𝐏𝐕4 )
𝐀𝐩𝐩𝐫𝐨𝐱. 𝐌𝐨𝐝𝐃𝐮𝐫 = = 𝟖. 𝟔𝟗𝟎𝟕
𝟐𝚫𝐲𝐢𝐞𝐥𝐝 (𝐏𝐕𝟎 ) (𝐏𝐕3 ) + (𝐏𝐕4 ) − (𝟐𝐏𝐕𝟎 )
𝐀𝐩𝐩𝐫𝐨𝐱. 𝐂𝐨𝐧. = = 𝟏𝟎𝟕. 𝟎𝟒𝟔
(𝚫𝐲𝐢𝐞𝐥𝐝)𝟐 𝐏𝐕𝟎
3. Calculate %𝚫PVfull for 𝚫yield = +100 bps.
%𝚫PVfull = (−𝟖. 𝟔𝟗𝟎𝟕 × 𝟎. 𝟎𝟏) + –𝟏6𝟐 (𝟏𝟎𝟕. 𝟎𝟒𝟔) × (𝟎. 𝟎𝟏)𝟐 —
= −𝟎. 𝟎𝟖𝟔𝟗𝟎𝟕 + 𝟎. 𝟎𝟎𝟓𝟑𝟓𝟐
= −𝟎. 𝟎𝟖𝟏𝟓𝟓𝟓
75
4. Compare est. %𝚫PVfull with actual %𝚫PVfull if YTM ⇒ 8.44% Pg-7
𝟕. 𝟐𝟓 𝟏𝟎𝟕. 𝟐𝟓 𝟖𝟑
𝐚𝐜𝐭𝐮𝐚𝐥 𝐏𝐕 𝐟𝐮𝐥𝐥 = 8 + ⋯+ : × (𝟏. 𝟎𝟖𝟒𝟒) 2𝟑𝟔𝟎 = 𝟗𝟏. 𝟕𝟖𝟎𝟗𝟐𝟏
(𝟏. 𝟎𝟖𝟒𝟒) (𝟏. 𝟎𝟖𝟒𝟒)𝟏𝟓
𝟗𝟏. 𝟕𝟖𝟎𝟗𝟐𝟏 − 𝟗𝟗. 𝟗𝟓𝟔𝟕𝟖

𝐀𝐜𝐭𝐮𝐚𝐥 %𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 = = −𝟎. 𝟎𝟖𝟏𝟕𝟗𝟒
𝟗𝟗. 𝟗𝟓𝟔𝟕𝟖
➞
𝐄𝐬𝐭. %𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 = −𝟎. 𝟎𝟖𝟏𝟓𝟓 [−𝟎. 𝟎𝟖𝟔𝟗𝟎𝟕 + 𝟎. 𝟎𝟎𝟓𝟑𝟓𝟐]
Actual - 8.1794%
Est. - 8.155% 2.44 bps. off
vs. ModDur only of – 8.6907%
Pg-8
Recall: MoneyDur. = 𝐀𝐧𝐧. 𝐃𝐮𝐫. × 𝐏𝐕 𝐟𝐮𝐥𝐥
𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 ≈ −𝐌𝐨𝐧𝐞𝐲 𝐃𝐮𝐫. × 𝚫𝐲𝐢𝐞𝐥𝐝
Well, money convexity results in,
𝟏
𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 ≈ (− 𝐌𝐨𝐧𝐞𝐲 𝐃𝐮𝐫. × 𝚫𝐲𝐢𝐞𝐥𝐝) + 8 𝐌𝐨𝐧𝐞𝐲𝐂𝐨𝐧. × (𝚫𝐲𝐢𝐞𝐥𝐝)𝟐 :
𝟐
first-order second-order effect
effect
𝐏𝐕/ + 𝐏𝐕= − (𝟐𝐏𝐕𝟎 )
➞ ⇐ 𝐀𝐩𝐩𝐫𝐨𝐱. 𝐂𝐨𝐧. =
when bond’s cash
(𝚫𝐲𝐢𝐞𝐥𝐝)𝟐 𝐏𝐕𝟎
flows do not change
𝐏𝐕/ + 𝐏𝐕= − (𝟐𝐏𝐕𝟎 )
when bond’s cash ⇐ 𝐄𝐟𝐟. 𝐂𝐨𝐧. =
(𝚫𝐜𝐮𝐫𝐯𝐞)𝟐 𝐏𝐕𝟎
flows change
both pos.
convexity
neg.
convexity callable
76
Yield Volatility Pg-9
𝟏
𝚫YTM %𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 ≈ (−𝐀𝐧𝐧. 𝐌𝐨𝐝𝐃𝐮𝐫 × 𝚫𝐲𝐢𝐞𝐥𝐝) + X 𝐀𝐧𝐧. 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 × (𝚫𝐲𝐢𝐞𝐥𝐝)𝟐 Y
𝟐
≈ Duration + Convexity
25 bps
impact/basis point change
Yield Volatility = # of ‘basis points’ change

time-to-
maturity
· non-parallel ➞
shifts Investment Horizon
Duration gap = MacDur – Investment horizon

if: duration gap < 0 ⇒ coupon re-investment risk
dominates market price risk
- risk is to lower rates
> 0 ⇒ market price risk dominates
coupon re-investment risk
- risk is to higher rates
Credit & Liquidity Risk

Corporate Bonds
Pg-10
Benchmark
+ Spread
rate
Inflation real credit

liquidity
expectations rate risk
Inflation ➞ Credit
Real Rate Liquidity
Duration Duration Duration Duration
typically interaction effects
i.e 𝚫 credit quality

Conditions leading to a 𝚫benchmark rate
𝚫 liquidity
may lead
to a…
77
Fundamentals of Credit Analysis
a. describe credit risk and credit-related risks affecting corporate bonds;
b. describe default probability and loss severity as components of credit risk;
c. describe seniority rankings of corporate debt and explain the potential of

violation of the priority of claims in a bankruptcy proceeding;
d. distinguish between corporate issuer credit ratings and issue credit ratings
and describe the rating agency practice of “notching”;
e. explain risks in relying on ratings from credit rating analysis;
f. explain the four C’s (Capacity, Collateral, Covenants, and Character) of

traditional credit analysis;
g. calculate and interpret financial ratios used in credit analysis;
h. evaluate the credit quality of a corporate bond issuer and a bond of that
issuer, given key financial ratios of the issuer and the industry;
i. describe factors that influence the level and volatility of yield spreads;
j. explain special considerations when evaluating the credit of high yield,

sovereign, and non-sovereign government debt issuers and issues.
78
Credit Risk
default risk loss severity

E(loss) – P(default) × (1 – Recovery rate)
= X %
AAA A BB B- C/D
ƒ (credit quality, size of debt)
liquidity market price
Recall, spread ≠
default transaction price
benchmark
credit migration risk
(i.e. downgrades)
Capital Structure & Seniority

specific assets
first lien/mortgage debt
Priority 2nd specific property
Secured
of 3 rd …
clai m s Senior Secured

Senior Unsecured * ⇒ all creditors at a given
Unsecured
Senior Subordinated level are treated as one
(not always Subordinated class
absolute) Junior Subordinated ∴ rank equally
“pari passu”
Recovery Rates vary by:
(on equal footing)
① Seniority
② Industry
③ stage of the credit cycle (economic cycle)
* most common corporate debt
79
Ratings
Moody’s S&P Finch Pg-1
· bonds will not sell without a rating

Issuer (CFR)
(Senior unsecured debt) vs. Issue (CCR)
AAA Issuer = Issue
P(default) primary
Issue 1 notch +/-
focus
AA issuer
E(loss) = P(default) × (1 – Recovery Rate)
(1 – Recovery Rate) more Issue 2 notches

important below issue
∴ 2 bonds with
Note: Ratings do not stay static over time equal ratings
Agencies can and have been wrong may have very
Ratings can’t incorporate unpredictable events different prices
Ratings tend to lag market pricing of risk
Credit Analysis ⇒ an assessment of ability to pay Pg-2
credit + industry
f quality fundamentals
f(sources, predicability, sustainability

4 C’s of credit of cash flows)
1) Capacity – ability to pay on time
A. Industry analysis Barriers
(Porter) to
• more credit risk Entry
• less credit risk low high
Supplier few Level of few Buyer
Power many Competition many Power
Structure few many
Substitution fragmented
Risk consolidated
80
4 C’s of credit Pg-3

1) Capacity ⇒ Structure con’t. fixed vs. variable cost structure
B. Fundamentals: · cyclical vs. non-cyclical

· growth prospects
· published industry statistics
C. Company Fundamentals · competitive position
· track record/operating history
· Mgmt. Strategy/execution
· Ratio analysis
Profitability and Leverage Coverage

Cash Flow

1) Capacity ① Profitability and Cash Flow
· EBITDA
· FFO (funds from operations)
· free-cash flow before dividends
(after dividends)
② Leverage (debt usually inclusive of debt-like
liabilities) i.e. leases
· Debt/Capital
Total Debt + Shareholder Equity
lower = less
risk
· Debt/EBITDA ⇒ lower = less risk
· FFO/Debt
81

1) Capacity ③ Coverage – ability to meet interest payments
· EBITDA/Interest Exp.
higher = less risk
· EBIT/Int.exp.
Liquidity ⇒ cash option

bigger
net working capital
consideration for
operating cash flow
high yield
committed bank lines
companies
debt coming due
1–2 years
committed CAPEX
2) Collateral ⇒ (1- Recovery Rate) focus
⇒ involves estimates of market value
· tangible vs. intangible asset issues
C’s of credit Pg-6

3) Covenants · affirmative (mgmt. is obligated to do)
· negative (mgmt. limited in doing)
in bond
prospectus
4) Character · soundness of strategy

· mgmt. track record
· actg. policies/tax strategies
· previous poor treatment of bond holders
82
Credit Risk vs. Return · Yields & Spreads Pg-1

· higher risk ⇒ higher potential return
· more volatility
· less certainty
Maturity
Premium Yield
Inflation Liquidity on
+ = Corporate
Premium Premium
Real Credit Bond
Rate (rf) Spread
gov’t corporate
Benchmark + Spread
Pg-2
Spread ⇒ affected by (issuer risk obviously, but also…)
A. Credit cycle
le)
B. Broader economic conditions
s.cyc
f(b u C. Financial market performance
D. Market making willingness (efficient OTC market)
E. Supply and demand
Spread risk ⇒ return impact from ≈ ( −𝐌𝐨𝐝𝐃𝐮𝐫 × 𝚫𝐒𝐩𝐫𝐞𝐚𝐝)

spread changes
+–𝟏6𝟐 𝐂𝐨𝐧𝐯. × (𝚫𝐒𝐩𝐫𝐞𝐚𝐝)𝟐 —
· already covered in detail

in Reading 55
83
Special Considerations
Pg-1
1. High Yield - below Baa3/BBB-
· greater focus on liquidity (cash flow analysis)
· debt structure ⇒ calculate debt/EBITDA ratio at each level
i.e. 𝟒𝟖𝟗𝟗6 “top-heavy”
Secured 4,899 𝟗𝟗𝟎 = 𝟒. 𝟗 𝐱
Sen. Unsec. 1,948 (𝟒𝟖𝟗𝟗 + 𝟏𝟗𝟒𝟖)6 capital structure
𝟗𝟗𝟎 = 𝟔. 𝟗 𝐱 • less borrowing
Sub. Deb. 764
capacity
7,611 𝟕𝟔𝟏𝟏6
𝟗𝟗𝟎 = 𝟕. 𝟕 𝐱
EBITDA 990
Parent look for
· debt
structural
· corporate structure
subs subordination
subs subs
· debt
· debt · debt
1. High Yield Pg-2

· Covenant analysis
· change of control put ⇒ in the event of acquisition, bond holders
can require full payment @ par
· restricted payments ⇒ limits amount of cash that can be

paid to shareholders
· limitations on liens ⇒ limits amount of secured debt
· restricted vs. unrestricted subsidiaries
debt Hold. Co.

res. res. unres..
Sub 1 Sub 2 Sub 3
“pari passu” · debt · debt · debt
84
2. Sovereign Debt ⇒ external offerings – issued in U.S.D. Pg-3

⇒ internal offerings – issued in local currency
1) ability to pay
look at
2) willingness to pay (sovereign immunity – investors
can’t force payment)
- considerations
· Political & economic profile ➞ income/capita
effectiveness ➞ growth prospects
stability ➞ population – growth, age
predictability ➞ G : C
➞ stability & sources of revenue
3. Municipal Debt ⇒ general obligation bonds (unsecured) Pg-3
- municipalities must balance their budgets
⇒ Revenue bonds
- issued for specific project financing
- debt service coverage ratio (DSCR)
(revenue for principal + interest)
85
REVIEWS
86
Defining Elements
Features/ Issuer · supranational organizations Pg-1

sovereign - review
· government state
non-sov.
· corporate prov.
quasi
GSEs
Maturity vs. Term to Maturity (tenor)
- overnight to 30+ years
< 1yr. - money market at time of issuance
> 1yr. - capital market
par
Par Value · face/maturity value
discount < 100
premium > 100
Coupon rate/frequency · stated rate paid annually

- plain vanilla/conventional - fixed rate
- FRNs - floating rate notes - reference rate + spread
- zero-coupon - issued at a discount, matures at par
coupon in one Pg-2

Features/ Currency - dual currency bonds - review
- principal in another
- currency option bonds
- bondholder chooses currency of each
coupon PMT
Credit Enhancement
subordination (senior 85%, junior 15%)
Internal over-collateralization
excess spread
Surety Bond/Guarantee
External
Letter of Credit
Covenants - affirmative - what an issuer must do
- negative - what an issuer will not do
- limits on debt, restrictions on dividends, restrictions on M & A,
negative pledges (i.e. nothing senior)
87
Bond - legally binding contract Pg-3

form of bond
- review
- need Bond Indenture (a.k.a. trust deed) obligation of issuer
- trustee - fiduciary for Bondholders rights of bondholders
- legal identity of issuer, legal form
Source of repayment proceeds/
· supranational - repayment of previous loans
· government - full faith & credit (taxes usually)
· corporate - cash flows (CFO)
· securitized - principal + interest PMTs of securities held
Asset/Collateral Backing/
secured (bonds)
· Senor ranking
unsecured (debentures)
Asset/Collateral Backing/ Pg-4

collateral trust bond
- review
· collateral quality equipment trust certificate
MBS/ABS
covered bonds (like securitization)
Legal/Regulatory/Tax/
· Domestic - issuer, country, currency all match
· Foreign - country & currency match, issuer does not
· Eurobond - issued outside jurisdiction of any country
- named after currency of denomination

(Eurodollar, Euroyen)
88
Legal/Regulatory/Tax/ normal income Pg-5

Tax · Interest long-term - cap gains tax rate
- review
· Capital gain short-term - usually income
· Zero-coupon - all interest (implied each yr.)
at
issuance Discount Bond - implied interest each yr.
only Premium Bond - implied capital loss each yr.
⇒ Structure of Cash Flows/
· plain vanilla - interest + principal (bullet bond)
at end
fully - interest + pr. each PMT
· amortizing bond
partially - interest + pr. each PMT +
balloon PMT at maturity
⇒ Structure of Cash Flows/ Pg-6

· Sinking Fund - some percentage of bond put aside each yr. - review
annual
· Fixed rate semi-annual · Floating rate
quarterly - reference + spread
· Step-up coupons variable (margin)
- coupon increases over time
· Credit-linked coupons · may have · cap - no higher
↓↑ with credit quality · floor - no lower
· PIK bonds - payment in kind · may be inverse floater
(w/toggle) (e.g. shares) - if Libor ↑, coupon ↓
· Deferred Coupons - no PMTs for first
few years, higher PMT after
· Index-Linked Bonds
e.g. equity index/inflation
89
⇒ Structure of Cash Flows/ coupon Pg-7

· inflation adjustments or - review
principal (zeros)
⇒ Contingency Provisions/ PMT ↑ as principal increases
- embedded options (capital indexed bonds)
call risk
① Callable bond - benefits issuer, holder
(higher coupon/lower price) reinvestment risk
· Make whole call = PV of 𝐢𝐧𝐭. + 𝐅𝐕
𝐠𝐨𝐯 ! 𝐭 𝐘𝐓𝐌
② Putable bond - benefits holder
+ 𝐬𝐩𝐫𝐞𝐚𝐝
· American - always callable/putable
· European - 1 call/pull date
· Bermuda - many call/put dates
Pg-8
⇒ Contingency Provisions/ - review
③ Convertible Bonds/ into common shares (call option)
- benefits holder e.g./ $20/sh.
conversion price = $/share
= 𝟏𝟎𝟎𝟎6𝟐𝟎 = 𝟓𝟎 shares
ratio = FV/conv. pr.
value = Pt × ratio if Pt < $20
Premium = Bt - (Pt × ratio) - below parity
Parity = Bt (Pt × ratio) if Pt > $20
- above parity
- forced conversion - if Pt > $20 for a
specified # of days, company calls bonds
at a lower price
④ Warrants
- not an embedded option
90
Issuance, Trading, Funding
Pg-1
Markets/ - review
gov’t/gov’t related supranational
Issuer sov./non-sov.
financials
corporate quasi.
non-financials largest
structured products
(securitized) smallest
investment grade (Baa3 or BBB – or higher)
Credit Quality
non-investment grade – high yield, speculative
(more risk)
Maturity < 1 yr. – money market
at issuance
> 1 yr. - capital market
Currency – determines what county’s interest rate determines price
Domestic
Geography Foreign legal, regulatory, tax regime of ‘issued-in’ country
Eurobond
Markets/ emerging Pg-2

Geography - review
developed 5 currencies
35 rates 7 time periods
fixed
Coupon
floating ➞ LIBOR - London Interbank Offered Rate
- unsecured loans between banks for up to 1 yr.
Primary Market (first time issuance)
① Public Offering - underwritten offering (firm commitment)
- buys whole issue, assumes inventory risk
- typically Investment Bank or syndicate
· issuer determines funding needs
· selects underwriter
· structures the offering marketing
· announcement date end of subscription period obtain ‘anchors’
grey market (found mkt.
· gauge demand for upcoming issues)
91
Pg-3
· Pricing Day - last day to commit
- review
· Issuing Phase - sales made, money transfers
· Closing Date - about 14 days later
② Best efforts Offering - investment bank acts as agent/broker
- commission only
- no risk of ownership
Issuance/Auctions - typically Descending price auction for gov’t
price bonds
bids solicited then ranked
quality
e.g./ Sell $50M - each pay their bid until issue is sold
cuml. or/ Modified Dutch - each bidder pays the
.1560 12 12 same price at which the issue clears
.1565 8 20 · non-competitive bids - pay the clearing
.1570 16 36 or avg. $
.1575 18 50 all pay this price
only 14 filled
Primary Market (Con’t) (first time issuance) Pg-4

non-underwritten - review
one/few
Private Placement
unregistered buyers
Secondary Market/ (already issued)
- dealer market - can act as principal/agent
(OTC)
- dealer acts as market maker · very
- exchange listed: very limited little retail
Settlement/ trading
T + 1 - gov’t/quasi gov’t (capital market)
T + 3 - corporate
same day - all money market
92
Bill - money market (pure discount) Pg-5

Sovereign Bonds/ Treasuries Note < 10 yr. coupon - review
Bond > 10 yr. bearing

- most recently issued - on the run
- most actively traded
- unsecured - full faith and credit only
- risk-free AAA (Fitch, S&P) Aaa (Moody’s)
(local currency)
- fixed rate (most common) - some floating (country specific)
- may be inflation - linked (Linkers)
Non-Sovereign Bonds/ - higher yields
- lower credit rating
- perhaps favourable tax treatment
Supranational Bonds/ typically plain vanilla Pg-6

- review
- must act as benchmark for countries w/non-liquid
bond markets
Quasi-gov’t/ - agency bonds
- not repaid by the gov’t but by the GSE itself
Corporate/ Private - typically floating ⇒ may be securitized at some point
Public
Commercial Paper - short term, unsecured
- usually issued by financial companies (or very large non-fin.)
- overnight to 1 yr. - EuroCP
to 270 days - U.S. CP
1
prime paper - P/A/F
Ratings 2
non-prime 3
93
Commercial Paper Pg-7

- retired by rolling over- issuer usually maintains backup LOC - review
U.S. CP/ EuroCP (issued internationally)
· discount basis (par) · interest bearing (par + interest)
· settles same day · settles T + 2
Corporate Notes/ 1 yr. < short ≤ 5 yrs.

notes
5 < med ≤ 12 yrs.
long > 12 yrs. - bonds
Contingency Provisions
· fixed or floating
coupons · callable
- annual, semi, quarterly
· putable
- secured, unsecured
· convertible
· 1-30 yrs.
Serial maturity - portion matures each yr.
Principal
term maturity
Short-Term Funding/ Pg-8

demand - review
Deposits savings
Retail
Banks money market savings
Wholesale
(short-term)
· Central Bank Funds

- overnight lending/borrowing
· Interbank Market
overnight funds
- banks lending to each other
term funds
+ 25bps
target
central bank
funds rate
- 25bps
non-negotiable
· Certificates of Deposit
negotiable
94
Repurchase Agreement/ Pg-9

- sale of a security w/agreement to buy back - review
$ repurchase
A B A B $ < value of security
term
securities $ (1 + repo rate) repo margin
· 1 day
- overnight repo
· more - term repo
· to maturity - repo to maturity (of the security)
Reverse Repurchase Agreement/
- the above, seem from B’s perspective
95
Fixed Income Valuation
N PMT I/Y PV FV Pg-1

- all bonds priced on 100-point system (i.e. 100%) - review
100 - par coupon = mkt. rate

greater than 100 - premium coupon > mkt. rate
Less than 100 - discount coupon < mkt. rate
① inverse relationship ⇒ as r ↑, prices ↓, as r ↓, prices ↑

② for the same coupon & TTM, |%𝚫𝐏| as r ↓ > |%𝚫𝐏| as r ↑
- prices are more volatile to the upside
③ for the same TTM, the lower coupon bond will be more price volatile
than a higher coupon bond
④ for the same coupon, longer-term will be more price volatile
Spot Rates/ rather than using one r for all PMTs Pg-2
(Zn) - review
- also called 𝑷𝑴𝑻 𝑷𝑴𝑻 𝑷𝑴𝑻 + 𝑭𝑽
𝑷𝑽 = + + ⋯ +
zero rates (𝟏 + 𝒁𝟏 ) (𝟏 + 𝒁𝟐 )𝟐 (𝟏 + 𝒁𝒏 )𝒏
will be the
period 1 period 2 period n
no-arbitrage price
spot spot spot
Flat, Accrued & Full Price/ pricing bonds between coupon dates
n = # of PMTs
𝑷𝑽𝒇𝒖𝒍𝒍 = 𝑷𝑽𝒇𝒍𝒂𝒕 + 𝑨𝑰
PMT PMT PMT
q𝒕6𝑻 × 𝑷𝑴𝑻r X
-
𝟑𝟎6 PV
𝟑𝟔𝟎 − 𝐜𝐨𝐫𝐩𝐨𝐫𝐚𝐭𝐞
(𝟏 + 𝐫) 𝐭6𝐓
𝐚𝐜𝐭𝐮𝐚𝐥6
𝐚𝐜𝐭𝐮𝐚𝐥 − 𝐠𝐨𝐯′𝐭
𝐭
∴ 𝐏𝐕𝐟𝐮𝐥𝐥 = 𝐏𝐕(𝟏 + 𝐫) 2𝐓
& 𝐏𝐕𝐟𝐥𝐚𝐭 = 𝐏𝐕𝐟𝐮𝐥𝐥 − 𝐀𝐈
96
Pg-3
Matrix Pricing/ for fixed rate bonds w/ no/little
- review
secondary market (or not yet issued)
- use liquid comparables (credit quality)
e.g. 3 yr., 4%
Coupon
3% 4% 5%
2 X X - avg. YTM 2 yr.
TTM 3 X - 3 yr. Interpolate for
4
5 X X - avg. YTM 5 yr.3 yr. YTM
- then calculate PV
estimated 3 yr. YTM - 3 yr. Treasury rate = required yield spread
maturity
- will be a different yield spread for each
credit rating
Yield Measures/ Periodicity - # of coupon payments/yr. Pg-4

- review
e.g./ 6% Coupons/yr.
60 1 annual - effective annual rate
2 × 30 2 semi - semi-annual bond basis yield
4 × 15 4 quarterly (bond equivalent yield)
12 × 5 12 monthly
𝐀𝐏𝐑 𝐦 𝐦 𝐀𝐏𝐑 𝐧 𝐧
V𝟏 + [ = V𝟏 + [
𝐦 𝐧
e.g./ 3 yr., 5% semi @ 104, r = 3.582%

. 𝟎𝟑𝟓𝟖𝟐 𝟐 𝐀𝐏𝐑 𝐧 𝟒
V𝟏 + [ = V𝟏 + [ APR4 = 3.566%
𝟐 𝟒
as m ↑, APRm ↓ APR - annual percentage

rate
97
Yield Measures/ Pg-5

- review
· street convention – yield measure that neglects
lower weekends/holidays
than )
· true yield – accounts for delays in PMTs caused by
bps
( 1 -2 weekends/holidays
· government equivalent yield – restates a 𝟑𝟎6𝟑𝟔𝟎 YTM to an
𝐚𝐜𝐭𝐮𝐚𝐥6
𝐚𝐜𝐭𝐮𝐚𝐥 𝐘𝐓𝐌
· current yield – annual 𝐏𝐌𝐓6𝐏𝐕
n o t 𝐟𝐥𝐚𝐭
common · simple yield (𝐚𝐧𝐧𝐮𝐚𝐥 𝐏𝐌𝐓 + 𝐬. 𝐭. 𝐚𝐦𝐨𝐫𝐭. 𝐨𝐟 𝐠𝐚𝐢𝐧/𝐥𝐨𝐬𝐬)

𝐏𝐕𝐟𝐥𝐚𝐭
⇒ Embedded Options
Callable · yield to first (second, third) call
· yield to worst
· YTM
Pg-6
⇒ Embedded Options/ typically require an options pricing
- review
model (Level2)
PV = option adjusted price + value of embedded option
- call
+ put
⇒ Floating Rate Notes/ · coupon tied to short-term rate (Libor)
· paid ‘in arrears’ quarterly or
· reference rate + quoted margin (QM) semi-annual
(spread)
PV = 100 if QM = DM
· required rate ➞ discount margin (DM)
PV > 100 if QM > DM
𝚫 credit risk ⇒ 𝚫DM
PV < 100 if QM < DM
on a PMT
date
98
Pg-7
PMT
⇒ Floating Rate Notes/ - review
(𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝐅𝐕 (𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝐅𝐕
𝐏𝐕 = 𝐦 + 𝐦 + …
𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌 𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌 𝟐
n𝟏 + 𝐦 p n𝟏 + p
𝐦
(1 + r) (1 + r)2
e.g./ 4-yr. quarterly, Libor + 125 bps @ 98
CPT I/Y = .009478
find DM if Libor = 2%
.009478 = 𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌
N = 16 PV = -98 FV = 100
PMT = 𝟐 + 𝟏. 𝟐𝟓 𝟒
= 𝟑. 𝟐𝟓6𝟒 =. 𝟖𝟏𝟐𝟓 DM = 0.017912 or 179 bps
𝟒
⇒ Money Market Securities/ 𝐝𝐚𝐲𝐬6
discount basis 𝐏𝐕 = 𝐅𝐕 × n𝟏 − 𝐲𝐫. × 𝐃𝐑p
simple interest basis
add-on basis 𝐅𝐕
𝐏𝐕 =
𝐝𝐚𝐲𝐬6
DR = discount rate AOR – add-on rate 𝟏+ 𝐲𝐫. × 𝐀𝐎𝐑
𝐅𝐕 Pg-8
⇒ Money Market Securities/
𝐏𝐕 = - review
𝐝𝐚𝐲𝐬6 𝐝𝐚𝐲𝐬6
𝐏𝐕 = 𝐅𝐕 × n𝟏 − 𝐲𝐫. × 𝐃𝐑p 𝟏+ 𝐲𝐫. × 𝐀𝐎𝐑
rearrange/
𝐅𝐕 − 𝐏𝐕 𝐝𝐚𝐲𝐬6
𝐲𝐞𝐚𝐫 𝐅𝐕 − 𝐏𝐕 n𝟏 + 𝐲𝐫. × 𝐀𝐎𝐑p
𝐃𝐑 = 6𝐝𝐚𝐲𝐬 V [
𝑭𝑽
(1 + r)
hence DR is understated 𝐲𝐞𝐚𝐫 𝐅𝐕 − 𝐏𝐕
𝐀𝐎𝐑 = 6𝐝𝐚𝐲𝐬 × V [
𝐏𝐕
e.g./ 90-day, 360 DCC, DR = 5.76% ⇒ AOR = 5.925%
[w/ 365 DCC]
⇒ Term Structures/ a) gov’t bond spot curve (· YTM on zeros)
YTM (one issuer, same credit Q, same currency)
upward flat
inverted
· all else
constant
normal
TTM
99
Pg-9
⇒ Term Structures/
- review
b) gov’t bond yield curve – coupon paying
Note: short end of curve ⇒ 1 mos., 3 mos., 1 yr. …
money mkt.
c) Par Curve – obtained from the - converted to BEY
spot curve
- each maturity is priced to par
d) Forward Curve 1y1y – 1 yr. from now, one yr. rate
2y1y – 2 yrs. from now, one yr. rate
1 yr. rate implied forward rate

IFR1,1
(1 + r1)(1 + IFR1,1)
- given a spot curve,
-
= (1 + r2) 2
- a forward curve can be
2 yr. rate derived
taxation Pg-10
⇒ Yield Spreads/ Benchmark + Spread - review
liquidity
Fixed macro factors credit risk
Rate
· typically some gov’t yield (most recently issued)
G-Spread – spread above gov’t I-Spread – spread above swap rate

corp. YTM rate Z-Spread – spread over gov’t spot rate
- gov’t YTM e.g./ · 6% annual corporate, 2 yrs. TTM
@ 100.125
· 2 yr., 4% annual gov’t @ 100.75
· 1 yr. spot = 2.10% 2 yr. spot = 3.65%
G-Spread/ corporate YTM = 5.932%
(2.327%)
TIM gov’t YTM = 3.605
Term Structure of
(N = 2, PMT = 4, FV = 100, PV = -100.75)
Credit Spreads
𝟔 𝟏𝟎𝟔
𝐙 − 𝐬𝐩𝐫𝐞𝐚𝐝 = 𝟏𝟎𝟎. 𝟏𝟐𝟓 = + = 𝟐. 𝟑𝟒𝟐𝟐%
(𝟏. 𝟎𝟐𝟏 + 𝐙)𝟏 (𝟏. 𝟎𝟑𝟔𝟓 + 𝐙)𝟐
100
Asset-Backed Securities
Pg-1
-review
⇒ Benefits SPV will typically have higher credit rating than originator
(of securitization) source of funding greater credit availability
increased loan origination less concentration risk
bankruptcy remoteness
Mortgages higher risk-adjusted returns
Auto Loans
Pool ABS/MBS Investors
CC Receivables
of
Students Loans
Assets
have a claim
has a claim
originator
Customer Consumer Co.
sells loans
Investor SPV - separate legal entity
AAA Pg-2
senior tranche -review
mortgages SPV BB $80M
$100M mezzanine tranche credit
C 15M tranching
equity tranche
losses occur from 5M
the bottom up - all principal goes to senior tranche
first, then mezzanine, then equity
· equity tranche
- usually retained by originator
senior 65%
· mezzanine tranche ➞ pooled with other
mezzanine tranches mezzanine 25%
(an ABS of ABS) equity 10%
⇒ Sequential Pay ABS/
A1
senior A2 different - each receives interest, but all principal
A3 TTM & goes to A1, then A2, then A3
A4 YTM - time tranching – redistributes prepay. risk
101
Rating Pg-3
A1 C absorbs all losses
-review
AAA A2 time tranching first
credit
A3 “first piece loss”
tranching
B B
C C
- if no credit risk, there would be no subordination (agency debt
- gov’t guarantee)
⇒ Residential MBS (RMBS)
- payments = principal + interest + prepayments
Loan-to-value Ratio = 𝐦𝐨𝐫𝐭𝐠𝐚𝐠𝐞
PMT in partial PMTs
𝐩𝐫𝐨𝐩𝐞𝐫𝐭𝐲 𝐯𝐚𝐥𝐮𝐞
full (curtailment)
· credit quality of borrower important
mortgage holder prepayment risk
· lockout period Pg-4

⇒ Pre-payment Risk/ -review
· penalty period
-
-
5yrs. 30yrs.
⇒ Interest Rate/ · fixed rate, level payment, fully amortizing
ceiling
e.g./ · adjustable rate mortgage (ARM)
30-yr., 200K @ 6% floor
N = 360 FV = 0 PV = 200,000 I/Y = .5%
CPT PMT = -1199.10
(P) i Principal
Amortization
PMT 1 1199.10 199.10 1000 199,800.90
Schedule
PMT2 1199.10 200.10 999 199,600,80
➞ recourse mortgage – lender can go after assets of borrower

for any short fall
➞ non-recourse – lender’s claim ends at the property backing the mortgage
102
agency MBS Pg-5

⇒ Guarantees/ 1) federal agency
- no credit risk -review
2) government sponsored agencies
- prepayment risk
3) private entities – non-agency MBS (credit + prepay. risk)
· conforming – size, LTV, documentation, insured
· non-conforming
𝒏
w – weight
- weighted average coupon rate (WAC) = ˆ 𝒘𝒊 𝒓𝒊
r – interest rate
𝒊<
on mortgage
𝑻
n - # of mortgages
- weighted average maturity (WAM) = ˆ 𝒘𝒊 𝑻𝒊
T - months
⇒ Prepayment Rate (speed) 𝒊<𝟏
remaining
𝐩𝐫𝐞𝐩𝐚𝐲𝐦𝐞𝐧𝐭 𝐢𝐧 𝐦𝐨𝐧𝐭𝐡 𝐭
𝐒𝐌𝐌𝐭 = · prepayments/month
𝐁𝐞𝐠. 𝐦𝐨𝐧𝐭𝐡𝐥𝐲 𝐁𝐚𝐥. 𝐭 − 𝐬𝐜𝐡𝐞𝐝𝐮𝐥𝐞𝐝 𝐏𝐌𝐓𝐬
based on historical
PrepayAmt.t = SMMt × (Beg. Bal.t – Sched. PMTs) observations
Conditional Prepayment Rate: CPR = 1 – (1 – SMM)12 – annualized SMM
0
no prepayments Pg-6
PSA Prepayment Rate -review
100
same speed as benchmark
e.g./ month 5 ➞ CPR = 1%
· CPR of .2%/month up to 6%
(PSA = 100)
· 6%, month 30 onwards
& 𝐂𝐏𝐑 = 𝟏 − (𝟏 − 𝐒𝐌𝐌)𝟏𝟐
𝟏2
𝐒𝐌𝐌 = 𝟏 − (𝟏 − 𝐂𝐏𝐑) 𝟏𝟐
⇒ Weighted Average Life/ how long an MBS lasts assuming

interest rates stay at current levels
- if r ↓, refinancing ↑, Prepayments ↑, PSA Speed ↑, Average Life ↓
- contraction risk: lower reinvestment of CF
- if r ↑, refinancing ↓, Prepayments ↓, PSA Speed ↓, Average Life ↑
- extension risk: lower CF for reinvestment
103
CMO/Collateralized Mortgage Obligation/ Pg-7

-review
Bond Class 1
pool of
MBS Bond Class 2 time tranching
etc…
· does not eliminate · different maturities
prepayment risk · different yields
protection from
extension risk ‘waterfall’
protection from (principal distribution)
contraction risk
⇒ Planned Amortization Class (PAC) + Support tranches/
offers both contraction & get $ over minimum

extension risk Principal payments
⇒ Non-Agency Credit Risk/ credit tranching
- internal credit enhancements reserve funds
overcollateralization
Pg-8
⇒ Non-Agency Credit Risk/
-review
external credit enhancement – Guarantee - Ins. Co.
(wrapped)
⇒ Commercial MBS (CMBS)/ income producing assets ➞ pool of CMBS
credit analysis of cash non-recourse

flows of each loan
⇒ Auto Loan Backed Securities/ - short-term, pr. + i + prepayments
- all have some form of credit enhancement
⇒ Credit Card Receivable Backed Securities/
- finance charges + interest + Principal
Principal
-
lockout/revolving period – all PR. reinvested in new loans

104
Collateralized Debt Securities/ Pg-9

-review
asset mgr.
selects senior
asset mezzanine
Debt pool
equity
Securities
ramp-up (buy assets)

-
-
0 1yr. Principal
revolving
repayment
period
⇒ Call Protection/ results in CMBS trading more like a corporate bond Pg-10
-review
1) prepayment lockout 2-5 yrs.
2) defeasance – borrower purchases securities as collateral
to cover remaining principal balance + an amount to substitute
for what yield would have been (defeasance premium)
3) prepayment penalty points YR.
5 4 3 2 1
105% 104% etc…
4) yield maintenance charge of prepayment amt.

- make whole charge (yield) if refinanced
105
Fixed-Income Risk and Return
⇒ Sources of Return 1) Coupon Payments - credit risk Pg-1

- review
2) Reinvestment of Coupon interest rate
3) Capital gain/loss risk
- YTM assumes/ · held to maturity
· no default
· coupons reinvested at YTM rate
Constant-yield Price Curve
100- if r ↓:
carrying value ⇒ purchase price - lower reinvestment
Cap. gain of bond + amortized discount of coupon BUT cap.
gain
(or -amort. of if r ↑: - higher
Cap. loss premium)
t reinvestment of
-
T coupon BUT cap. loss
⇒ Duration/ measures the sensitivity of the bond’s full price to changes Pg-2
in r - review
· represents approx. amt. of time a bond would have to be
held be held for the YTM to be realized
PV (+)𝐫𝐞𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐨𝐟
e.g. Duration = 5 yrs. if rates ↑,
𝐜𝐨𝐮𝐩𝐨𝐧
(−) 𝐜𝐚𝐩. 𝐥𝐨𝐬𝐬
r ➞ = ∅ 𝐢𝐟 𝐡𝐞𝐥𝐝 𝐟𝐨𝐫 𝟓 𝐲𝐫𝐬.
Macauley
· yield duration
modified
𝚫YTM
money
PVBP
gov’t yield curve used with
· curve duration - effective 𝚫benchmark spot curve complex
yield forward curve bonds
par yield curve · financial
assets/liab.
106
⇒ Duration/ 𝐰𝐞𝐢𝐠𝐡𝐭𝐞𝐝
𝐧 𝟏 × 𝐏𝐌𝐓 𝟐 × 𝑷𝑴𝑻 𝑵 × (𝑷𝑴𝑻 + 𝑭𝑽) Pg-3
8 + + ⋯+ : - review
𝐌𝐚𝐜𝐃𝐮𝐫 = ˆ 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰𝐬 (𝟏 + 𝐫) (𝟏 + 𝒓)𝟐 (𝟏 + 𝒓)𝒏
𝐏𝐕𝐟𝐮𝐥𝐥
𝐢<𝟏
𝐌𝐚𝐜𝐃𝐮𝐫 i.e. if semi annual

𝐌𝐨𝐝𝐃𝐮𝐫 = must be annualized
(𝟏 + 𝐫) then ÷ 2
%𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 ≈ − 𝐀𝐧𝐧. 𝐌𝐨𝐝𝐃𝐮𝐫 × 𝚫𝐲𝐢𝐞𝐥𝐝 - linear estimate

r ↓ ➞ PV ↑ (requires a convexity
if 𝚫𝐲𝐢𝐞𝐥𝐝
r ↑ ➞ PV ↓
adjustment)
(𝐏𝐕/ ) − (𝐏𝐕= ) - for small 𝚫𝐲𝐢𝐞𝐥𝐝:
𝐀𝐩𝐩𝐫𝐨𝐱. 𝐌𝐨𝐝𝐃𝐮𝐫 =
𝟐 × 𝚫𝐲𝐢𝐞𝐥𝐝 × 𝐏𝐕𝟎 Approx.ModDur = Ann.ModDur
(𝐏𝐕/ ) − (𝐏𝐕= ) Approx.MacDur = Approx.ModDur (1+r)
for complex bonds – requires an option pricing model
⇒ Duration/ Pg-4
assumes a parallel shift in yield curve - review
· EffDur - for a callable bond, may be called if

· credit spread decreases (credit duration)
· benchmark yield decreases (curve duration)
also used for
FRNs, MBS, DBPP
· 𝚫yield is based on spot curve
· 𝚫curve is based on par curve, so…
- flatter the par curve
- shorter the bond EffDur ≈ ModDur
- closer price is to par
⇒ Key Rate Duration/
- duration at a specific maturity on the

yield curve
- a key rate dur. can
· to get %𝚫𝐏𝐨𝐫𝐭. 𝐕𝐚𝐥𝐮𝐞, must use
be calculated for each
Key Rate Duration
maturity
maturities
-
-
-
-
-
-
-
-
-
-
107
Pg-5
⇒ Key Rate Duration/ - review
(𝐏𝐕/ ) − (𝐏𝐕= )
𝐊𝐞𝐲𝐑𝐚𝐭𝐞𝐃𝐮𝐫 = - each key
𝟐 × 𝚫𝐫𝐚𝐭𝐞 × 𝐏𝟎
rate may
have a
11 of different 𝚫rate
𝟏𝟏
these
⇒ ˆ 𝐊𝐑𝐃 = 𝐄𝐟𝐟𝐃𝐮𝐫
maturities
-
-
-
-
-
-
-
-
-
𝐢<𝟏
11 maturities 𝐌𝐚𝐭 𝟏 𝐌𝐚𝐭 𝟐
%𝚫𝐏𝐨𝐫𝐭. 𝐕 = 𝐊𝐑𝐃𝟏 V [ + 𝐊𝐑𝐃𝟐 V [
𝐏𝐕 𝐏𝐕
𝐌𝐚𝐭 𝟏𝟏
+ ⋯ + 𝐊𝐑𝐃𝟏𝟏 V [
⇒ Properties of Duration 𝐏𝐕
D
D 𝚫t c, r, N - constant zero coupon bond (D=TTM)
discount bond
𝟏4𝐫
Z 𝐫
[Perpetuity
premium bond
TTM
PMT PMT
⇒ Properties of Duration/ Pg-6

D - review
- as TTM ↑, Duration ↑
- as coupon ↓, Duration ↑ more interest
- as YTM ↓, duration ↑ rate risk
TTM
⇒ Duration of a Bond Portfolio

1) weighted average of time to receipt of the
aggregate cash flows (requires CF yield – not practical)
2) weighted average on individual bond Durations
𝐁𝟏 𝐁𝟐 𝐁𝐧
𝐀𝐯𝐠. 𝐌𝐨𝐝𝐃𝐮𝐫 = 𝐌𝐨𝐝𝐃𝐮𝐫𝟏 | } + 𝐌𝐨𝐝𝐃𝐮𝐫𝟐 | } + ⋯ + 𝐌𝐨𝐝𝐃𝐮𝐫𝐧 | }
𝐁𝐩 𝐁𝐩 𝐁𝐩
𝐧 𝐌𝐚𝐜𝐃𝐮𝐫
ˆ 𝐁𝐢 = 𝐁𝐩 & 𝐌𝐨𝐝𝐃𝐮𝐫 =
𝐘𝐓𝐌
𝟏+ 𝐦
𝐢<𝟏
108
⇒ Money Duration/ Money Dur. = Ann.ModDur ×PVfull Pg-7

𝚫PV = - MoneyDur. × 𝚫yield
full - review
e.g./ PVfull = 100.940243 MoneyDur. = 618.44178
Ann.ModDur = 6.1268 if YTM ↑ 100 bps, 𝚫PVfull = -618.44178 × .01)
⇒ Price Value of a Basis Point (PVBP)/ = -6.1844178 /100
of par value
(𝐏𝐕! ) − (𝐏𝐕" )
𝐏𝐕𝐁𝐏 = ⇒ 𝚫PV for 𝚫1bp.
full
𝟐
⇒ Convexity Adjustment/
first-order effect second-order effect

𝐟𝐮𝐥𝐥
𝟏
%𝚫𝐏𝐕 = (−𝐀𝐧𝐧. 𝐌𝐨𝐝𝐃𝐮𝐫 × 𝚫𝐲𝐢𝐞𝐥𝐝) + 8 𝐀𝐧𝐧. 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 × (𝚫𝐲𝐢𝐞𝐥𝐝)𝟐 :
𝟐
1st order 2nd order
(𝐏𝐕/ ) + (𝐏𝐕= ) − (𝟐𝐏𝐕𝟎 )
if 𝚫bp+ neg. pos.
𝐏𝐕𝟎 (𝚫𝐲𝐢𝐞𝐥𝐝)𝟐
if 𝚫bp- pos. pos.
⇒ Money Convexity/ Pg-8

𝟏 - review
%𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 ≈ (−𝐌𝐨𝐧𝐞𝐲𝐃𝐮𝐫. × 𝚫𝐲𝐢𝐞𝐥𝐝) + 8 𝐌𝐨𝐧𝐞𝐲𝐂𝐨𝐧𝐯𝐞𝐱. × (𝚫𝐲𝐢𝐞𝐥𝐝)𝟐 :
𝟐
first-order second-order
effect effect
⇒ Duration GAP/
(MacDur. – Investment Horizon)
< 0 - coupon reinvestment risk dominates market price risk
- risk is to lower rates
> 0 - market price risk dominates coupon reinvestment risk
- risk is to higher rates
⇒ Yield Volatility/ 𝚫YTM
25 bps -
TTM
109
Credit Analysis
Default Risk E(loss) = P(default) Pg-1

⇒ Credit Risk - review
loss severity ×
(1- Recovery Rate)
- spread credit quality
liquidity = x %
+ size of debt
benchmark default (credit migration risk) i.e. downgrades
⇒ Priority of Claims/ first lien/mortgage
all become
2nd
senior unsecured
secured 3rd
if not paid in full
senior secured
senior unsecured
unsecured senior subordinated
subordinated all rank
junior subordinated ‘pari passu’
Seniority
⇒ Recovery Rates vary by/
Industry
stage of business cycle
high quality AAA to AA- Pg-2

⇒ Ratings/ · investment grade - review
upper medium A+ TO A-
(default premium & low medium BBB+ to BBB-
liquidity premium small)
low grade BB+ TO C
· non-investment grade
default D
- also/ Positive – Stable – Negative

⇒ Notching/ company rating ⇒ on senior unsecured
⇒ each debt issue will also have a rating
· Investment grade · issue rating +/- 1 notch the issuer rating
· Non-investment grade · issue rating -up to 2 notches the issuer rating
2 bonds with equal ratings
different outlook
may have very different prices
different recovery rates
110
⇒ 4 C’s of Credit/ an assessment of ability to pay Pg-3

- review
- credit quality + industry fundamentals
① Capacity – ability to pay on time

A. Industry analysis (e.g. Porter’s 5-forces)
high credit risk ⇒ few buyers/suppliers, low barriers, many
substitutes, fragmented
B. cyclical vs. non-cyclical, growth prospects
C. Company Fundamentals – leverage, solvency
Profit & Cash Flow Leverage Coverage

- EBITDA Debt/Capital EBITDA/Int. Exp.
- FFO Debt/EBITDA
EBIT/Int. Exp.
- FCF – before Div. FFO/Debt
⇒ 4 C’s of Credit/ Pg-4

② Collateral/ (1- Recovery Rate) - review
estimates of mv. of assets

③ Covenants/ affirmative
negative
④ Character/ mgmt. track record, soundness of strategy
⇒ Credit Risk/ liquidity premium + risk spread
spread + benchmark
affected by/ · credit cycle
· economic conditions
· market performance
· supply and demand
return impact from ≈ ( −𝐌𝐨𝐝𝐃𝐮𝐫 × 𝚫𝐒𝐩𝐫𝐞𝐚𝐝) + –𝟏6 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 × (𝚫𝐒𝐩𝐫𝐞𝐚𝐝)𝟐 —
𝟐
spread changes
111
Pg-5
⇒ Special Considerations in Credit Analysis/ - review
1) High Yield – more interested in loss severity
- greater focus on liquidity (1- Recovery Rate)
- ‘top-heavy’ cap. structure loss given
= high % of debt as secured default
parent - debt
structural
debt
sub sub sub subordination Hold. Co. restricted
debt debt debt res. res. unres.. vs.
sub sub sub
unrestricted
debt debt debt
subsidiaries
restricted by
debt agreement at Hold Co. level
- covenant analysis
· restricted PMTs to shareholders, restrictions on
liens, etc …
⇒ Special Considerations in Credit Analysis/ Pg-6

- review
2) Sovereign Debt - ability to pay
- willingness to pay (sovereign immunity – investors
can’t force PMT)
3) Municipal Debt · general obligation bonds
- unsecured
- municipalities must balance their budgets
· revenue bonds (installment debentures)
- for specific projects
112

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Last Revised: 12/15/2020

Level I - Fixed Income

Fixed-Income Securities: Defining Elements 2

Fixed-Income Markets: Issuance, Trading, and Funding 15

Introduction to Fixed-Income Valuation 26

Introduction to Asset-Based Securities 42

Understanding Fixed-Income Risk and Return 63

Fundamentals of Credit Analysis 78

© markmeldrum.com. All rights reserved.

Fixed-Income Securities: Defining Elements

a. describe basic features of a fixed-income security;

b. describe content of a bond indenture;

c. compare affirmative and negative covenants and identify examples of each;

e. describe how cash flows of fixed-income securities are structured;

f. describe contingency provisions affecting the timing and/or nature of cash

Fixed - Income Securities: Defining Elements

structured special purpose entities (securitization → ABS, MBS)

⇒ Basic Features/ LOS a

- range → from overnight to 30 years (or longer)

⇒ Basic Features/ LOS a

⇒ Basic Features/ LOS a

5/ Currency Denomination - can be issued in any currency

⇒ Yield Measures/ current or running yield 𝐚𝐧𝐧𝐮𝐚𝐥 𝐜𝐨𝐮𝐩𝐨𝐧 LOS a

⇒ Bond Indenture LOS b

issuer trustee → typically a financial institution with trust

• trust deed includes/

⇒ Bond Indenture LOS b

⇒ Bond Indenture LOS b

⇒ Bond Indenture LOS b, c

⇒ Bond Indenture LOS b, c

→ Legal/Regulatory Considerations/ LOS d

favourable ordinary income

- reduces credit risk

⇒ Bullet, Fully-amortizing, Partially amortizing bonds LOS e

balloon payment required = $200

⇒ Sinking fund arrangements/ LOS e

⇒ Coupon payment structure/ LOS e

⇒ Coupon payment structure/ LOS e

⇒ Bonds with contingency provisions/ LOS f

1/ Callable Bonds - issuer has the right to embedded ‘option’

⇒ Bonds with contingency provisions/ LOS f

⇒ Bonds with contingency provisions/ LOS f

- bonds with warrants → attached warrants

Fixed-Income Securities: Issuance, Trading, and Funding

a. describe classifications of global fixed-income markets;

b. describe the use of interbank offered rates as reference rates in floating-rate

c. describe mechanisms available for issuing bonds in primary markets;

d. describe secondary markets for bonds;

e. describe securities issued by sovereign governments;

f. describe securities issued by non-sovereign governments, quasi-government

g. describe types of debt issued by corporations;

h. describe structured financial instruments;

i. describe short-term funding alternatives available to banks;

Issuance, Trading, Funding

⇒ Classification of Fixed-Income Markets/ LOS a

· structured finance – securitization (MBS, ABS)

⇒ Classification of Fixed-Income Markets/ LOS a, b

- highest/lowest 25% discarded

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