Fixed Income... The lurking giant

Good topic. No idea what to expect on the exam from fixed income. I’ve always struggled with the “simple” foward pricing and rate models… par/spot/forward curves. All the way back to Level 1, ugh. Seeing as how it’s the first part of the first reading I take that as “this is the easiest stuff, what is wrong with you?”. But I always find myself frozen when I get asked a question on it.
The binomial trees are just all about careful inputs, knowing when to call/put/add OAS/caps/floors, etc. Going to make sure and go slow on those. Structural/reduced form will definitely be a part of it but I think all conceptual. As for ABS… just gotta know your instruments and how they work.
Definitely doing a quick run through of the BBs for these readings today as my final topic prep. I can’t possibly do anything more for FRA than pray, so FI is my last ditch effort to grab some points.
 
  • Auto loan ABS are amortizing
  • Credit card ABS are non-amortizing, excess prepayment is used to buy more securities during lockout period
  • CMBS are non-recourse, ballon risk is most common, they have more call protection than RMBS
  • CPR is an annual measure of prepayment, SMM is a monthly rate
  • Sequential pay CMO pays principal to the short tranche first
  • Shifting interest mechanism restores the ratio of Senior/Sub to maintain credit exposure
  • Defesance protection invests prepayment in T-bills for investor as compensation
  • Yield maintence charge protection forces borrower to pay the same interest even after prepayment
Add more for ABS reading!
 
^^ good stuff.. i feel like the concept questions from this topic will be hard and the calculations more basic
 
SMM = repayment / (beginning month principal / scheduled repayment)
The higher the PSA, the lower the average life, the higher the contraction risk
Interest rates fall? More people will refinance their debt obligations, PSA increases
There is Loan-Level (defeasance, prepayment lockout, prepayment fee, yield maintenance) protection and Structural Level protection (sequential pay and support/pac duo)
Gross interest = WAC * beginning obligation
Net interest = passing-through rate * beginning obligation
PMT - Gross interest = scheduled repayment
Total cash outflow = net interest + scheduled repayment + prepayment
CMOs re-allocate extention and contraction risks (differentiation)
CDOs have managers buying and selling collateral, trying to maximize the subordonate tranche
 
Synthetic CDOs buy and sell derivatives on collaterals, like CDS.
We need a thread like this on derivatives and FRA…
 
This_is_not_easy wrote:
… On another fixed income note, did anyone see in the CFAI mock fixed income section the question regarding the putable bond’s value in realtion to the straight bond’s value if the economists interest rate predicitons held and the straight bond value didn’t change?
So the economist predicted the yield curve will start to become upward sloping and he also predicted that yield volatility would decrease. Maybe I looked at it wrong, but I couldn’t figure out how to tell which action would effect the putable bond more.
The answer was that the putable bond increases in value. How do you know the upward sloping yield curve would effect the value of the putable bond more than the decline in interest rate volatility?
Click to expand...
Didn’t see anyone answer this – the trick is the question only asks “if the shape of the curve changes, what’ll happen?” So you gotta ignore the volatility change. Just like the question before asks “if the vol changes, what happens?”, so for that one you ignore the steepening.
 
Let me add something from my memory
Convertible Bonds
  • Conversion ratio is the number of common stocks that the bond holders receive from converting the bonds into shares. Ex: 1 bond = 14,000 share => conversion ratio: 14,000
  • Conversion value = Underlying share price x conversion ratio
  • Minimum value of a convertible bond = Max [ conversion value , value of the underlying option free bond]
  • Market Conversion Price = Convertible Bond Price/Conversion ratio
  • Market conversion premium per share = Market conversion price - Underlying share price
  • For convertible bonds with put option : (1) Hard put: the issuer must redeem the convertible bond for cash (2) Soft put: the issuer may redeem the convertible bond for cash, common stock, subordinted note and/or combination of the three
  • For convertible bonds with call option: The issuer can call the bond when (1) interes rates are falling (2) its credit ratings are revised upward (3) The underlying share price increases above the conversion price (i.e: forced conversion => strengthen the issuer’s capital structure)
Price behavior of a convertible bond and the underlying common stock
  • Share price WELL BELOW conversion price: Convertible bond price behavior similar to straight bond price => Bond equivalent
  • Share price BELOW conservsion price and increases towards it : Hybrid instrument
  • Share price ABOVE conversion price and decreases towards it: HYbrid instrument
  • Share price WELL ABOVE conversion price: Convertible bond price behavior similar to stock. In this case changes in interests don’t make significant changes in the price of convertible bond.
 
I feel terribly overconfident about fixed income right now and I really really don’t like this feeling. Argh!
Cfai should’ve given more practice q on this
 
Mmhmm. I finished up my review this morning and I feel really good on all 5 readings, however I wasn’t able to practice on much of it. Bah.
And like I said in a previous topic, FI was my bread and butter going into L1 and it was exceedingly difficult on exam day. That was troubling.
 
I hope they ask a question on put/call parity.
Then a question on if interest rates goes up, what happens to call or put options
Then calculate the CPR given the SMM or CPR, calculate SMM
Come on CFAI!! Help us out!!!
 
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