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CFA Level 3 - Fixed Income 2 (13,14)

Terms in this set (47)

Two key points about yield curves

1st has to do with often taking the yield curve as given
2nd has to do with trade off between two things
1. The curve isn't exact maturities, for example many have to be interpolated or modeled based on other markets

2. a tradeoff exists between YTM and liquidity. while off the run bonds may earn a higher return if held to maturity -- buying and selling them will ikley involve increased trading costs
Yield curve curvature formula
-short yield + 2*mediumterm - long yield
Let's say butterfly spread is NEGATIVE ---- is the curve concave or convex
Convex (the middle term is way less )
Duration is more focused on the change in the _________
while convexity is more focused on ______+_________

Word bank
slope,level,curvature
duration = level

Convexity = slope & curvature
3 strategies for a static yield curve
1. buy and hold and earn cpn
2. roll down curve - buy past investment horizon (adding duration) if curve is positively sloped
3. Repo carry trade - buy long end and finance at short end -- need repo rate to be less than coupon rate
2 strategies for static yield curve - Derivatives
1. Long futures position
2. receive fixed swap
T/F if there is an inverted yield curve you will face a NEGATIVE carry when financing a bond purcahse in the repor market
TRUE
Scenario for a bull steepener
Monetary authority cuts benchmark rates to stimulate activity during a recession
Scenario for a bear steepener
jump in long term rates amid higher growth and inflation expectations while short term rates remain unchanged

analyst might start to expect the next CB policy decision to be a monetary tightening to curb inflation
Scenario for bear flattener
might follow a bear steepener

if policymakers respond to rising inflation expectations and higher long term rates by raising short term policy rates
Scenario for bull flattner
long term rates falling more than short term

usualy in a flight to quality
T/F you can generate a positive rolldown return from being short a negative yielding bond
TRUE
Why is the butterfly spread usually positive
because the difference between the short and intermediate term bonds are usually larger than the difference between medium term and long term
Interest rate call options are generally based on Price or YTM?
Price
If an investor uses a forward contract to fully hedge foreign currency cash flows, then they should expect to earn _________________________ (what rate)
the domestic risk free rate
Best strategy if you think a positive butterfly will occur
PURCHASE BULLET

SELL Barbell
active fund trader seeks to capitalize on an expected steepening of the current upward sloping yield curve using option based fixed income instruments

which of the following portfolio positioning strategies best positions her to gain if her interest rate view is realized

A. Purcahse a 30YR receiver swaption and a 2 year bond put option
B. Purchase a 30YR payer swaption and a 2YR bond call option
C. Sell a 30YR receiver swaption and a 2 year bond put option
B. Purchase the 30YR payer swaption and a 2YR bond call option

In option C you are only limited to the option premia as you sell both
Are credit spreads directly observable
no - they are derived from market information
If a curve is upward sloping -- the roll down return is likely higher or lower using an interpolated bmk
LOWER
How is empirical duration usually estimated
by running a regression of its price returns on changes in a bennchmark interest rate
ASW is an estimate of the spread over _________
estimate of the spread over MRRvs. the bonds original coupon rate

So difference between coupon and the swap rate
T/F The yield spread for a corporate bond will be equal to the G spread if the government benchmark yield is flat
TRUE
Excess spread =
Spread0 - (effSpreadDUR chg in spread) - (PoD LGD)
Excess Spread over 6 months
Spread0 0.5 - (effSpreadDUR chg in spread) - (PoD LGD .5)
T/F Structural credit models define the likelihood of default as the probability of the asset value falling below that of liabilities
TRUE
Which of the following phases of the credit cycle typically involves a DECLINE in the # of issuer defaults?

A. Early Expansiion
B. Late Expansion
C. Peak Phase
B. Late expansion

they are at peak in the early expansion
then decline
then are stable in peak phase
then rise in contraction
If their is an upward sloping yield curve - is the Z-DM or DM higher?
Z-DM will be BELOW the DM
When does the high yield credit curve begin to invert?
During a recession

NOT during peak phase
Why should investors exercise caution in interpreting credit spread curve shapes for distressed debt issuers
because their bonds tend to trade on a price rather than credit spread basis as the likelihood of default increases

It does not trade on YTM because the investor doesn't believe it will receive these coupon payments anymore
A sythentic credit curve roll down strategy involves PURCHASING/SELLING protection using a single name CDS contract for a longer maturity
SELLING

think of it as buying a riskier bond -- you would want to sell protection and pick up that credit premium
T/F Spread comparisions are accurate only when comparing bonds with the same maturities but DIFFERENT coupons
TRUE
The spread over an MRR based benchmark can be interpreted as a ___________ rather than ______________ credit risk measure for a given bond issuer

A. Relative
B. Absolute
It can be interpreted as a relative rather than absolute credit risk measure
What is a limitiation to Ispreads
limited to option free bonds because it uses yield levels on the curve RATHER than using term structure of rates
The Z spread is more accurate than either the G or I spread but what is the downside
it is more complex using models
CDS Spread 3%
Bond Spread on IG 3.5%

is this a negative or positive basis
Negative basis

If a negative basis exists, it means that the cash bond is the cheap asset and the credit default swap is the expensive asset

Buy the bond and buy the CDS
Describe an OAS
the constant yield spread over the ZERO CURVE which makes the arbitrage free value of such a bond equal to its market price
What is the Z spread for an option free bond
simply its OAS assuming zero volaitilty
Valuing a Floating rate bond
PV = (MRR + QM) * Face value / m
----------------------------
(1 + MRR+DM/m)^n)
What is the Quoted Margin (QM)
the yield spread over the MRR established upon issuance to compensate investors for assuming the credit risk of the issuer
Does QM reflect changes of credit risk changes over time?

What does?
no it does not

DM does.... DM would fall on an upgrade
if floating rate note's PV < FV

A. QM < DM
B. QM > DM
QM < DM
T/F Reduced form models solve for default intensity or the POD over a time period
using observable company specific variables like financial ratios and recovery assumptions as well as macroeconomic variables
TRUE
Who uses market based variables
A. Reduced form
B. Structural
B. Structural uses market based variables
Z-score would be related to reduced form or structural
REDUCED FORM BECAUSE company specific variables
VaR formula
Yield volatility std dev sqroot of trading days

PV per 100 notional
Soverign ceiling concept in emerging markets
the ceiling implies that a companys rating is typically no higher than the sovereign credit rating of its domicile
Most important ratio to assess the soverign borrowers liquidity position

A. Government budget deficit / GDP
B. External Debt / GDP
C. Currency Reserves / GDP
C. it measures the available liquidity in foreign currency to meet external obligations
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