Fixed Income Securities
Final Exam Solution
1. Briefly explain why many corporations prefer to issue callable long-term corporate bonds rather than noncallable long-term bonds.
There are three main reasons why a corporation may be interested in calling a bond. * Interest rated have fallen, so they can refinance at a lower rate. * Credit quality has improved, so they can refinance at a lower rate. * Assets have been sold, so money is available to pay off debt.
2. Briefly explain the idea behind an Immunized Bond Portfolio.
With an Immunized Portfolio, the duration and convexity of the assets is set to match the duration and convexity of the liabilities. The PV of the assets is set greater than the PV of the liabilities. For small changes in yield, the asset value should increase or decrease proportionally to the changes in the value of the liabilities. This method insures that the return on the assets and the return on the liabilities remain the same. Another way of looking at it is that immunization sets the price risk exactly equal to the reinvestment risk.
3. Explain why an Interest Only Strip (IO MBS) usually gains value when interest rates increase.
IO Strips receive the interest portion of a MBS. If interest rates decrease, then prepayments should speed up. If this happens, then smaller payments are received in the future. While these smaller payments are discounted at a lower rate, the net effect is usually a decrease in value.
4. Briefly explain what happens to the price of a straight bond (no options) when the yield increases – and why.
Price goes down when yields go up. I needed you to tell me why. I accepted any of the three reasons from the Bond Analytics lecture notes.
5. Briefly describe how the Federal Reserve moves rates in the Federal Funds Market.
The Federal Reserve cannot trade in the Federal Funds Market. However, banks have other alternatives for raising cash to deposit with the Federal Reserve. The Fed can trade in those markets to change yields. The Repo Market is their most common tool, though they can also change the Discount Rate for borrowing funds from the Fed. In addition, they can change the Reserve Requirements.
6. Suppose that you want to hedge the interest rate risk of a Fixed Income Security that has negative convexity. Suppose that you can create a perfect hedge with futures and options (paying a premium to buy the options). As an alternative, you can use hedge with futures alone. If you believe that the true volatility will be much lower than the implied volatility of the options, which alternative should you choose? Why?
If you believe that the implied volatility of the options is too high, then you would also believe that the options are overpriced. It would be cheaper to hedge with futures alone if you are right.
7. Briefly explain the idea behind splitting a companion CMO tranche into a floating rate class and an inverse rate floating rate class.
Breaking the companions into a floater and inverse floater does not change the prepayments – but affects the level of risk associated with it. Floaters have very little price risk – so prepayments do not have much of an effect on price (unless there is a low cap). There is reinvestment risk for floaters, but those investing in floaters will not mind prepayments, since they are reinvested at a similar rate. Inverse Floaters will be very sensitive to prepayments. However, faster prepayments increase the values. In addition, these are highly convex, long duration instruments, so they can be hedged with futures. Many people only discussed the Floater and neglected to discuss the Inverse Floater. Many said that if the cap is hit, these become fixed cash flow bonds (so less risk). They do not. They become fixed rate bonds that have a lot of prepayment risk. Several people mentioned the cap being a present value (despite the fact that I...