[Level 1] Revision Phase with SAPP

Buổi 16 - Fixed Income - Reading 44: Introduction to Fixed Income Valuation, Reading 45: Introduction to Asset Backed Securities


Question 44.1: A company has two $1,000 face value bonds outstanding both selling for $701.22. The first issue has an annual coupon of 8% and 20 years to maturity. The second bond has the same yield to maturity as the first bond but has only five years remaining until maturity. The second issue pays interest annually as well. What is the annual interest payment on the second issue?

A) $18.56.
B) $27.18.
C) $37.12.


C is correct. First find the yield to maturity (YTM) of the first bond and use it in the second bond calculation. The calculator sequence to determine the YTM is: PV = –701.22; FV = 1,000; PMT = 80; N = 20; CPT → I/Y = 12.00%. We discount the cash flows of the second bond at 12.00%. The calculator steps are: PV = –701.22; FV = 1,000; N = 5; I/Y = 12; CPT → PMT = $37.12.

Question 44.2:
An analyst collects the following spot rates, stated as annual BEYs:
6-month spot rate = 6%.
12-month spot rate = 6.5%.
18-month spot rate = 7%.
24-month spot rate = 7.5%.
Given only this information, the price of a 2-year, semiannual-pay, 10% coupon bond with a face value of $1,000 is closest to:
A) $918.30.
B) $1,000.00.
C) $1,046.77.
C is correct. This question can be answered without calculations. Since the spot rates are less than the coupon rate, the price must be greater than par value, so C is the only possible correct choice. This is a four-period bond with $50 cash flows each period.
Step 1: Divide each spot rate by two to get the semiannual rate.
PV: N = 1; I/Y = 3.00; FV = $50; CPT → PV = $48.54
PV : N = 2; I/Y = 3.25; FV = $50; CPT → PV = $46.90
PV : N = 3; I/Y = 3.50; FV = $50; CPT → PV = $45.10
PV : N = 4; I/Y = 3.75; FV = $1,050; CPT → PV = $906.23.
Step 2: Sum to get $1,046.77.

Question 44.3: If the yield curve is downward-sloping, the no-arbitrage value of a bond calculated using spot rates will be:
A) equal to the market price of the bond.
B) less than the market price of the bond.
C) greater than the market price of the bond.
A is correct. The value of a bond calculated using appropriate spot rates is its no-arbitrage value. If no arbitrage opportunities are present, this value is equal to the market price of a bond.


Question 44.4: A 10%, 10-year bond is sold to yield 8%. One year passes, and the yield remains unchanged at 8%. Holding all other factors constant, the bond's price during this period will have:
A) increased.
B) decreased.

C) remained constant.
B is correct. The bond is sold at a premium. As time passes, the bond's price will move toward par. Thus, the price will fall. N = 10; FV = 1,000; PMT = 100; I = 8; CPT → PV = $1,134
N = 9; FV = 1,000; PMT = 100; I = 8; CPT → PV = $1,125


Question 44.5: Consider the following Treasury spot rates expressed as bond equivalent yields:

Maturity         Spot Rate
6 months           3.0%
1 year                3.5%
1.5 years           4.0%
2 years              4.5%
If a Treasury note with two years remaining to maturity has a 5% semiannual coupon and is priced at $1,008, the note is:
A) overpriced.
B) underpriced.
C) correctly priced.


Question 44.6: A hedge fund manager is estimating a value for a non-traded bond of Yoder Company. The bond has an annual-pay 6% coupon, matures in six years, and has a CCC credit rating. Actively traded annual-pay bonds with similar credit ratings include the following:
Coupon   Maturity   Yield to maturity
8%               5 years           9.45%
5%               5 years           9.55%
7%             10 years         10.00% .
Based on matrix pricing, the value of the Yoder bond as a percentage of par is closest to:

A) 9.
B) 1.
C) 5.

B is correct. To find an appropriate discount rate for the Yoder bond, first take the average of the 5-year bonds: (9.45% + 9.55%) / 2 = 9.50% Next, use linear interpolation to estimate a yield for a bond with six years to maturity: 9.50% + [(6 − 5) / (10 − 5)] × (10.00% − 9.50%) = 9.60% Finally, discount the Yoder bond's cash flows at this rate: N = 6; I/Y = 9.6; PMT = 6; FV = 100; CPT PV = –84.14

Question 44.7: The full price of a bond:
A) includes accrued interest.
B) includes commissions and taxes.
C) is also known as the “clean” price.


A is correct. The full price is clean price plus accrued interest.

Question 44.8:
Kathy Hurst, CFA, is valuing a 4-year zero coupon security and has acquired the following information: 1-year spot rate 6.0%; 4-year spot rate 7.5%; 1-year forward rate 1 year from now 7.3%; 1-year forward rate 3 years from now 8.9%. The 1-year forward rate 2 years from now is closest to:
A) 7.3%.
B) 7.8%.
C) 8.0%.


Question 44.9: Jefferson Blake, CFA, believes there is a good opportunity to purchase an option-free 4% annual pay bond with three years left until maturity, a zero-volatility spread of 40 basis points, and a par value of $1,000. Blake observes that 1-year, 2-year, and 3-year government bond spot rates are currently 4.0%, 4.5%, and 4.75%, respectively. The maximum price Blake should be willing to pay for the bond is closest to:
A) $940.
B) $970.
C) $980



Question 44.10: A bond with nine years to maturity is quoted at an interpolated spread of +150 basis points. The benchmark yield for this bond is:
A) a swap rate.
B) a matrix rate.
C) a government bond yield.

A is correct. Interpolated spreads (I-spreads) are spreads to swap rates.

Question 44.11: The bonds of Grinder Corp. trade at a G-spread of 150 basis points above comparable maturity U.S. Treasury securities. The option adjusted spread (OAS) on the Grinder bonds is 75 basis points. Using this information, and assuming that the Treasury yield curve is flat:
A) the option cost is 75 basis points.
B) the zero-volatility spread is 75 basis points.
C) the zero-volatility spread is 225 basis points.

A is correct. The option cost is the difference between the zero volatility spread and the OAS, or 150 − 75 = 75 bp. With a flat yield curve, the Gspread and zero volatility spread will be the same


LOS 45.a: Explain benefits of securitization for economies and financial markets
Question 45.1: Securitization least likely benefits the financial system by:
A) increasing the amount banks are able to lend.
B) removing liabilities from bank balance sheets.
C) increasing liquidity for mortgages and other loans.
B is correct. By enabling banks to raise cash by selling their existing loans and mortgages (which are balance sheet assets for banks), securitization increases the amount banks are able to lend.
Schweser note:
Securitization refers to a process by which financial assets (e.g., mortgages, accounts receivable, or automobile loans) are purchased by an entity that then issues securities
supported by the cash flows from those financial assets. The primary benefits of the
securitization of financial assets are (1) a reduction in funding costs for firms selling the
financial assets to the securitizing entity and (2) an increase in the liquidity of the underlying
financial assets.

LOS 45.b: Describe securitization, including the parties involved in the process and the roles they play

Question 45.3: Asset-backed securities (ABS) may have a higher credit rating than the seller's corporate bonds because:
A) they are issued by a special purpose entity.
B) the seller’s ABS are senior to its corporate bonds.
C) ABS are investment grade while corporate bonds may be speculative grade.
(Reading 45, LOS 45.c)
A is correct. The SPE in a securitization is bankruptcy-remote from the seller, which means the seller's creditors do not have a claim against the pool of assets underlying an ABS. As a result, the ABS may have a higher credit rating than the seller's corporate bonds.
Schweser note
ABS are most commonly backed by automobile loans, credit card receivables, home equity
loans, manufactured housing loans, student loans, Small Business Administration (SBA) loans, corporate loans, corporate bonds, emerging market bonds, and structured financial products.

LOS 45.c: Describe typical structures of securitizations, including credit tranching and time tranching & LOS 45.g: Describe characteristics and risks of commercial mortgage-backed securities

Question 45.4: Which of the following mortgage-backed securities is most likely to feature credit tranching?
A) Collateralized mortgage obligations.
B) Commercial mortgage-backed securities.
C) Agency residential mortgage-backed securities.
B is correct. Commercial mortgage-backed securities often feature credit tranching in which subordinated tranches are the first to absorb credit losses. Sequential-pay CMOs employ time tranching in which all principal payments flow to Tranche 1 up to its principal amount, then to Tranche 2 up to its principal amount, and so on. Agency RMBS are pass-through securities and do not feature credit tranching or time tranching.
Schweser note
With credit tranching, the ABS tranches will have different exposures to the risk of default
of the assets underlying the ABS. With this structure, also called a senior/subordinated
structure, the subordinated tranches absorb credit losses as they occur (up to their principal
values). The level of protection for the senior tranche increases with the proportion of
subordinated bonds in the structure.
CMBS mortgages are structured as nonrecourse loans, meaning the lender can only look to the collateral as ameans to repay a delinquent loan if the cash flows from the property are insufficient. Incontrast, a residential mortgage lender with recourse can go back to the borrower personallyin an attempt to collect any excess of the loan amount above the net proceeds from
foreclosing on and selling the property. For these reasons, the analysis of CMBS securities focuses on the credit risk of the property and not the credit risk of the borrower. 

LOS 45.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 & LOS 45.f: Define prepayment risk and describe the prepayment risk of mortgagebacked securities.

Question 45.5:
Consider a collateralized mortgage obligation (CMO) structure with one planned amortization class (PAC) class and one support tranche outstanding. If the prepayment speed is higher than the upper collar on the PAC:
A) the life of the PAC tranche will increase.
B) the PAC tranche has no risk of prepayments.
C) the life of the support tranche will decrease.
C is corect. If the prepayment speed is higher than the PAC collar, the support tranche receives more prepayments. The life of the support tranche will shorten. The PAC tranche could receive higher prepayments if the support tranche principal is fully repaid (i.e., a broken PAC). In this case, the support tranche is still outstanding, which means that hasn't happened yet.
Schweser note
Reducing the prepayment risk of the PAC tranches is achieved by increasing the prepayment
risk of the CMO’s support tranches. If principal repayments are more rapid than expected, the
support tranche receives the principal repayments in excess of those specifically allocated to
the PAC tranches. Conversely, if the actual principal repayments are slower than expected,
principal repayments to the support tranche are curtailed so the scheduled PAC payments can
be made. The larger the support tranche(s) relative to the PAC tranches, the smaller the
probability that the cash flows to the PAC tranches will differ from their scheduled payments.

Question 45.6: A collateralized mortgage obligation with agency RMBS as the collateral is least likely to be created to offer securities with less:
A) default risk than the underlying RMBS.
B) extension risk than the underlying RMBS.
C) prepayment risk than the underlying RMBS.
A is correct. Agency CMOs are created to reapportion prepayment risk, which includes extension and contraction risk. Agency CMOs have little or no default risk because they are backed by the government or by GSEs

Question 45.7: What is most likely to happen to the prepayment rate and the weighted average life of a typical pass-through security if mortgage rates decrease?
A) Both will increase.
B) Both will decrease.
C) One will increase and one will decrease
C is correct. Prepayment rates will most likely increase if mortgage rates decrease. Increasing prepayments will decrease the weighted average life of the pass-through security.
Schweser note: 
Agency RMBS are mortgage pass-through securities. Each mortgage pass-through security
represents a claim on the cash flows from a pool of mortgages.  The mortgages in the pool typically have different maturities and different mortgage rates. The weighted average maturity (WAM) of the pool is equal to the weighted average of the final maturities of all the mortgages in the pool, weighted by each mortgage’s outstanding principal balance as a proportion of the total outstanding principal value of all the mortgages in the pool.

LOS 45.d: Describe types and characteristics of residential mortgage loans that are typically securitized.

Question 45.8: A mortgage is most attractive to a lender if the loan:
A) is convertible from fixed-rate to adjustable-rate.
B) has a prepayment penalty.
C) is non-recourse.
B is correct. Prepayment penalties are attractive to a lender because borrowers are most likely to prepay when interest rates have decreased (i.e., when the lender will earn a lower return by reinvesting prepaid principal). Recourse loans are more favorable to the lender than non-recourse loans because with a non-recourse loan the lender can only reclaim the collateral in the event of default, while recourse gives the lender a claim against the borrower's other assets. The conversion option in a convertible mortgage is held by the borrower and is therefore attractive to a borrower rather than a lender.

LOS 45.g: Describe characteristics and risks of commercial mortgage-backed securities

Question 45.9: Commercial mortgage-backed securities (CMBS) loans typically have greater call protection than agency MBS loans because:
A) commercial mortgages may have yield maintenance charges.
B) smaller-sized mortgages typically are not refinanced if interest rates fall.
C) CMBS typically receive higher credit ratings from credit agencies than residential MBS.
A is correct. Any type of call protection structured into the loan itself (in this case, yield maintenance charges) increases the overall call protection of the CMBS. Agency MBS do not provide call protection at the individual loan level.
Schweser note
To create CMBS-level call protection, CMBS loan pools are segregated into tranches with a
specific sequence of repayment. Those tranches with a higher priority will have a higher
credit rating than lower priority tranches because loan defaults will first affect the lower
tranches. A wide variety of features can be used to provide call protection to the more senior
tranches of the CMBS.

LOS 45.h: Describe types and characteristics of non-mortgage asset-backed securities, including the cash flows and risks of each type.

Question 45.10: Asset-backed securities with a lockout period are most likely to be backed by:
A) automobile loans.
B) home-equity loans.
C) credit card receivables.
C is correct. Asset-backed securities backed by credit card receivables have a lockout period, during which principal repayments are reinvested in additional receivables.

LOS 45.i: Describe collateralized debt obligations, including their cash flows and risks.

Question 45.11: A synthetic collateralized debt obligation is backed by a portfolio of:
A) credit default swaps.
B) structured securities.
C) bonds and other CDOs.
A is correct. Synthetic CDOs have portfolios of credit default swaps as the underlying collateral.
Schweser note
Collateralized debt obligation (CDO) is a generic term used to describe a security backed by a diversified pool of one or more debt obligations: CDOs backed by corporate and emerging market bonds are collateralized bond obligations (CBOs); CDOs backed by leveraged bank loans are collateralized loan obligations (CLOs); CDOs backed by ABS, RMBS, CMBS, and other CDOs are structured finance CDOs; CDOs backed by a portfolio of credit default swaps for other structured securities are synthetic CDOs.

Question 45.12: With respect to auto-loan backed ABS:
A) the underlying loans are collateralized so no credit enhancement is necessary.
B) some of them have some sort of credit enhancement.
C) all of them have some sort of credit enhancement.
C is correct. All automobile loan ABS have some sort of credit enhancement to make them attractive to institutional investors.