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Fixed Income I Problem Solving Session

Fixed Income I Problem Solving Session. Harvard Extension School MGMT E-2900b CFA Exam Level I March 23, 2010. Fixed Income I Problem Solving Session. Rich Gibble Lecturer Tray Spilker Teaching Assistant. Fixed Income. Topic Area Weights for the CFA Exam.

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Fixed Income I Problem Solving Session

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  1. Fixed Income I Problem Solving Session Harvard Extension School MGMT E-2900b CFA Exam Level I March 23, 2010

  2. Fixed Income I Problem Solving Session Rich Gibble Lecturer Tray Spilker Teaching Assistant

  3. Fixed Income Topic Area Weights for the CFA Exam

  4. Fixed Income I Problem Solving Session Features of Debt SecuritiesOverview of Bond Sectors & InstrumentsRepayment & Prepayment Provisions • Study Session 15 • Readings 60 & 62

  5. Fixed Income - Basic Concepts • A bond’s indenture: • outlines interest and principle components • is the same as a debenture • contains its covenants

  6. Fixed Income - Basic Concepts • A bond’s indenture: • outlines interest and principle components • is the same as a debenture • contains its covenants

  7. Bond Indenture • A bond indenture specifies all rights and obligations of the issuer and bondholder. • Contains: • negative covenants or restrictions on the borrower/issuer • affirmative covenants, or obligations of the borrower.

  8. Fixed Income - Basic Concepts • A five-year bond, after paying no interest for the first two years, pays $103.76 and $25 semiannually for the remaining three years until maturity. At maturity it pays $1,000. Which of the following bonds types is the closest to the bond described? • Accrual bond • Deferred-coupon bond • Step-up note

  9. Fixed Income - Basic Concepts • A five-year bond, after paying no interest for the first two years, pays $103.76 and $25 semiannually for the remaining three years until maturity. At maturity it pays $1,000. Which of the following bonds types is the closest to the bond described? • Accrual bond • Deferred-coupon bond • Step-up note

  10. Coupon Rate Structures • Accrual Bonds: pay no periodic coupon before maturity, but are sold at par and pay-out par plus accrued at maturity. • Deferred Coupon Bonds: Initial coupon payments are deferred for some period; the accrued coupons are paid at the end of the period, before resuming normal couponing until maturity. • Step-Up Notes: have coupon rates that increase over time at a specified rate.

  11. Fixed Income - Basic Concepts • From the perspective of the bond issuer, which of the following pairs of options would add value to a straight bond? • Prepayment option, put option • Call option, accelerated sinking fund provision • Conversion option, put option

  12. Fixed Income - Basic Concepts • From the perspective of the bond issuer, which of the following pairs of options would add value to a straight bond? • Prepayment option, put option • Call option, accelerated sinking fund provision • Conversion option, put option

  13. Provisions for Bond Retirements • Call options, sinking fund provisions, caps on floaters, and prepayment options favor the issuer. • Put options, conversion options, and floors on floaters favor the bondholder.

  14. Fixed Income - Basic Concepts • A bond with a $2,500 par value and a coupon rate of 7% makes semiannual payments. What is the dollar amount of each semiannual coupon payment? • $87.50 • $70.00 • $175.00

  15. Fixed Income - Basic Concepts • A bond with a $2,500 par value and a coupon rate of 7% makes semiannual payments. What is the dollar amount of each semiannual coupon payment? • $87.50 • $70.00 • $175.00 $2,500 (0.07/2) = $87.50

  16. Fixed Income - Basic Concepts • A $1,000 five-year semiannual 5% coupon bond issued when the market requires a yield of 6% will sell at (a) _______ for a total price of _______? • Par, $1,000 • Premium, $1,043.76 • Discount, $957.35

  17. SS 15: Fixed Income - Basic Concepts • A $1,000 five-year semiannual 5% coupon bond issued when the market requires a yield of 6% will sell at (a) _______ for a total price of _______? • Par, $1,000 • Premium, $1,043.76 • Discount, $957.35

  18. Fixed Income - Basic Concepts N=10, I/Y=3%, PMT=$25, FV=$1,000 • compute PV = $957.35 Since the bond sells for less than face value, it sells at a discount

  19. Fixed Income - Basic Concepts • A $5 million floating-rate semiannual note is issued with a reference and spread of 6-month LIBOR + 250bps. The rate was most recently reset on January 1 when LIBOR was 6% and the risk free rate was 1.5%. How much will the next semiannual coupon payment be? • $112,500 • $425,000 • $212,500

  20. Fixed Income - Basic Concepts • A $5 million floating-rate semiannual note is issued with a reference and spread of 6-month LIBOR + 250bps. The rate was most recently reset on January 1 when LIBOR was 6% and the risk free rate was 1.5%. How much will the next semiannual coupon payment be? • $112,500 • $425,000 • $212,500 $5 mln [(0.06 + 0.025)/2] = $212,500

  21. Fixed Income - Basic Concepts • Which statement regarding caps and floors on floating rate bonds is least accurate? • Caps are a disadvantage to the bondholder, while floors are a disadvantage to the issuer • Floors are a disadvantage to the bondholder, while caps are a disadvantage to the issuer • Caps are an advantage to issuers, while floors are an advantage to bondholders

  22. Fixed Income - Basic Concepts • Which statement regarding caps and floors on floating rate bonds is least accurate? • Caps are a disadvantage to the bondholder, while floors are a disadvantage to the issuer • Floors are a disadvantage to the bondholder, while caps are a disadvantage to the issuer • Caps combined with floors are called collars

  23. Caps & Floors on Floating-Rate Bonds Caps: if rates move above the cap rate, the issuer only pays the cap rate  advantage issuer Floors: if rates move below the floor rate, the issuer still pays the floor rate  advantage bondholder

  24. Fixed Income - Basic Concepts • A 5% semiannual, $1,000 face value bond is quoted at a 2.7% discount to par. The quote is made mid-way between coupon payment dates. What is the bond’s clean price, dirty price and accrued interest? • $960.50, $973.00, $12.50 • $973.00, $985.50, $12.50 • $950.00, $1,000.00, $50.00

  25. Fixed Income - Basic Concepts • A 5% semiannual, $1,000 face value bond is quoted at a 2.7% discount to par. The quote is made mid-way between coupon payment dates. What is the bond’s clean price, dirty price and accrued interest? • $960.50, $973.00, $12.50 • $973.00, $985.50, $12.50 • $950.00, $1,000.00, $50.00

  26. Bond Quotes and Accrued Interest Full Price = Clean Price + Accrued Interest • Full (Dirty) Price = quoted or selling price = $1,000(1 – 0.027) x = $973 • Accrued Interest = $1,000(0.05/4) = $12.50 • Clean Price = Full Price – Accrued Interest = $973 – $12.50 = $960.50

  27. Fixed Income - Basic Concepts Questions 9 – 12: Consider a 15-year, $10 million par value, 7.5% coupon bond issued on Jan 1, 2010. The bonds are callable but non-refundable at 105 for the first five years and 103 thereafter until maturity. There is a sinking fund provision requiring redemptions of $666,667 of the principal per year at par. Current market rates for comparable bonds are 7%.

  28. Fixed Income - Basic Concepts Questions 9 – 12: • Based on the above, investors can conclude: • they will pay a premium for the call option • the bonds were issued at a premium • the bonds do not have call protection

  29. Fixed Income - Basic Concepts • Based on the above, investors can conclude: • they will pay a premium for the call option • the bonds were issued at a premium • the bonds do not have call protection

  30. Fixed Income - Basic Concepts • Based on the above, investors can conclude: • they will pay a premium for the call option • Benefit of call option accrues to the issuer • the bonds were issued at a premium • Indeterminable: call option calls for a discount while coupon variance calls for a premium • the bonds do not have call protection • The call calendar begins from the date of issuance; The bonds are callable but non-refundable at 105 for the first five years and 103 thereafter until maturity.

  31. Fixed Income - Basic Concepts Questions 9 – 12 (cont.): • Based on the above, which of the following statements is least accurate regarding the sinking fund provision? • The bonds have an accelerated sinking fund provision. • An investor would not benefit if their bonds were redeemed under the provision. • The issuer would benefit if they delivered cash against the provision.

  32. Fixed Income - Basic Concepts • Based on the above, which of the following statements is least accurate regarding the sinking fund provision? • The bonds have an accelerated sinking fund provision. • An investor would not benefit if their bonds were redeemed under the provision. • The issuer would benefit if they delivered cash against the provision.

  33. Fixed Income - Basic Concepts • Explained • There was no provision for an accelerated sinking fund. • Bond will be trading at a premium because coupon rate > current market rate. Thus, a call at par would not benefit the investor. • The issuer would likely deliver cash to the trustee (at par) rather than buying bonds at a premium in the open market to satisfy the call.

  34. Fixed Income - Basic Concepts Questions 9 – 12 (cont.): • Based on the above, if the bonds were called on July 1, 2015, an investor who purchased the entire issuance would receive? • $10,300,000 • $10,500,000 • $10,000,000

  35. Fixed Income - Basic Concepts • Based on the above, if the bonds were called on July 1, 2016, an investor who purchased the entire issuance would receive? • $10,300,000 • $10,500,000 • $10,000,000 “The bonds are callable but non-refundable at 105 for the first five years and 103 thereafter until maturity.” • Call between 1/1/10 – 12/31/15 = 105 x $10mln = $10.5mln • Call between 1/1/16 – Maturity = 103 x $10mln = $10.3mln

  36. Fixed Income - Basic Concepts Questions 9 – 12 (cont.): • Based on the above, if the bonds were not callable and had no sinking fund provision, they would have been issued at a ______ for $_______? • Discount, $9,554,269 • Premium, $10,455,395 • Premium, $10,459,801

  37. Fixed Income - Basic Concepts • Based on the above, if the bonds were not callable and had no sinking fund provision, they would have been issued at a ______ for $_______? • Discount, $9,554,269 • Premium, $10,455,395 • Premium, $10,459,801

  38. Fixed Income - Basic Concepts • Explained • N = 30, I/Y = 0.07/2 = 3.5%, PMT = 0.075/2 x $10mln = $375,000, FV = $10mln  Compute PV = $10,459,801 • Unless specified otherwise, bonds are assumed to be semiannual pay

  39. Fixed Income - Basic Concepts • An investor buying bonds on margin: • will pay higher funding costs than they would if using a repurchase agreement (repo) • pays interest on a loan collateralized by the bonds • loans the bonds to an institution “overnight”

  40. Fixed Income - Basic Concepts • An investor buying bonds on margin: • will pay higher funding costs than they would if using a repurchase agreement (repo) • pays interest on a loan collateralized by the bonds • loans the bonds to an institution “overnight”

  41. Fixed Income - Basic Concepts • Explained • Margin loans require the payment of interest to the lender and are typically at higher rates than a repurchase agreement. • A Repurchase agreement allows an institution to sell a security with a commitment to buy it back at a later date. Typically lower implied interest due to the fact that the “lender” holds the collateral during the term.

  42. Fixed Income - Basic Concepts • Which of the following is most likely a provision for the early retirement of debt? • A put option • A conversion option • A prepayment option

  43. Fixed Income - Basic Concepts • Which of the following is most likely a provision for the early retirement of debt? • A put option • A conversion option • A prepayment option • A prepayment option allows the borrower/issuer the right to prepay the loan balance prior to maturity

  44. Fixed Income - Basic Concepts • A mortgage is most likely: • an amortizing loan • characterized by unstable cash flows • a bullet maturity loan

  45. Fixed Income - Basic Concepts • A mortgage is most likely: • an amortizing loan • characterized by unstable cash flows • a bullet maturity loan • Amortizing securities make periodic principle and interest over the life of the bond, whereas a bullet maturity bond pays periodic interest over the life of the bond and a large principle payment at maturity. • Mortgages often have prepayment options, thus make cash flows unpredictable due to the possibility of prepayment.

  46. Fixed Income - Basic Concepts • A treasury quoted at 95:15 with par value of $100,000 has a dollar equivalent quote of: • $95,468.75 • $100,000.00 • $95,150.00

  47. Fixed Income - Basic Concepts • A treasury quoted at 95:15 with par value of $100,000 has a dollar equivalent quote of: • $95,468.75 • $100,000.00 • $95,150.00 • 95(15/32)% x $100,000 • = 0.9546875 x $100,000 • = $95, 468.75

  48. Fixed Income - Basic Concepts • A $1,000 par value TIPS bond carries a 3% semiannual coupon. If the annual inflation rate is 5%, what is the principal value of the bond and coupon payment after six months. • $1,030, $15.45 • $1,025, $15.38 • $1,050, $15.75

  49. Fixed Income - Basic Concepts • A $1,000 par value TIPS bond carries a 3% semiannual coupon. If the annual inflation rate is 5%, what is the principal value of the bond and coupon payment after six months. • $1,030, $15.45 • $1,025, $15.38 • $1,050, $15.75 • Adjusted principle = $1,000(1+0.05/2) = $1,025 • Coupon = new principle x coupon rate = $1,025(0.03/2) = $15.375 ≈ $15.38

  50. Fixed Income - Basic Concepts • Ceteris paribus, put the following three equal par value bonds in order from highest to lowest value: (1) a Treasury note (T-note) principal strip that has six months remaining until maturity, (2) a Treasury bond (T-bond) coupon strip with six months remaining until maturity, and (3) a newly issued six-month Treasury bill (T-bill): • 1 < 2 < 3 • 3 < 2 < 1 • 1 = 2 = 3

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