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CFA Level II Chartered Financial Analyst Questions 3–7 (page: 62)

William Rogers, a fixed-income portfolio manager, needs to eliminate a large cash position in his portfolio. He would like to purchase some corporate bonds. Two bonds that he is evaluating are shown in Exhibit I. These two bonds are from the same issuer, and the current call price for the callable bond is 100. Assume that the issuer will call if the bond price exceeds the call price.

Rogers is also concerned about increases in interest rates and is considering the purchase of a putable bond. He wants to determine how assumed increases or decreases in interest rate volatility affect the value of the straight bonds and bonds with embedded options. After Rogers performs some analysis, he and his supervisor, Sigourney Walters, discuss the relative price movement between the two bonds in Exhibit 1 when interest rates change significantly
During the discussions, Rogers makes the following statements:

Statement 1: If the volatility of interest rates decreases, the value of the callable bond will increase.
Statement 2: The noncallable bond will not be affected by a change in the volatility or level of interest rates.
Statement 3: When interest rates decrease, the value of the noncallable bond increases by more than the callable bond.
Statement 4: If the volatility of interest rates increases, the value of the putable bond will increase.

Walters mentors Rogers on bond concepts and then asks him to consider the pricing of a third bond. The third bond has five years to maturity, a 6% annual coupon, and pays interest semiannually. The bond is both callable and putable at 100 at any time. Walters indicates that the holders of the bond's embedded options will exercise if the option is in-the-money.



Rogers obtained the prices shown in Exhibit b using software that generates an interest rate lattice. He uses his software to generate the interest rate lattice shown in Exhibit 2.

Exhibit 2: Interest Rate Lattice (Annualized Interest Rates)


The market value of the embedded call option in Exhibit 1 is closest to:

William Rogers, a fixed-income portfolio manager, needs to eliminate a large cash position in his portfolio. He would like to purchase some corporate bonds. Two bonds that he is evaluating are shown in Exhibit I. These two bonds are from the same issuer, and the current call price for the callable bond is 100. Assume that the issuer will call if the bond price exceeds the call price.

Rogers is also concerned about increases in interest rates and is considering the purchase of a putable bond. He wants to determine how assumed increases or decreases in interest rate volatility affect the value of the straight bonds and bonds with embedded options. After Rogers performs some analysis, he and his supervisor, Sigourney Walters, discuss the relative price movement between the two bonds in Exhibit 1 when interest rates change significantly
During the discussions, Rogers makes the following statements:

Statement 1: If the volatility of interest rates decreases, the value of the callable bond will increase.
Statement 2: The noncallable bond will not be affected by a change in the volatility or level of interest rates.
Statement 3: When interest rates decrease, the value of the noncallable bond increases by more than the callable bond.
Statement 4: If the volatility of interest rates increases, the value of the putable bond will increase.

Walters mentors Rogers on bond concepts and then asks him to consider the pricing of a third bond. The third bond has five years to maturity, a 6% annual coupon, and pays interest semiannually. The bond is both callable and putable at 100 at any time. Walters indicates that the holders of the bond's embedded options will exercise if the option is in-the-money.



Rogers obtained the prices shown in Exhibit b using software that generates an interest rate lattice. He uses his software to generate the interest rate lattice shown in Exhibit 2.

Exhibit 2: Interest Rate Lattice (Annualized Interest Rates)


For this question only, ignore the information from Exhibit 1 and any other calculations in other questions. Rather, assume that the interest rate lattice provided in Exhibit 2 is constructed to be arbitrage-free. However, when Rogers calculates the price of the callable bond using the interest rates in the lattice, he gets a value higher than the market price of the bond.

Is the price of the third callable and putable bond likely to be less than, equal to, or greater than 100%, and is the option-adjusted spread (OAS) on the callable bond likely to be zero, positive, or negative?

Price of third bond OAS of callable bond

William Rogers, a fixed-income portfolio manager, needs to eliminate a large cash position in his portfolio. He would like to purchase some corporate bonds. Two bonds that he is evaluating are shown in Exhibit I. These two bonds are from the same issuer, and the current call price for the callable bond is 100. Assume that the issuer will call if the bond price exceeds the call price.

Rogers is also concerned about increases in interest rates and is considering the purchase of a putable bond. He wants to determine how assumed increases or decreases in interest rate volatility affect the value of the straight bonds and bonds with embedded options. After Rogers performs some analysis, he and his supervisor, Sigourney Walters, discuss the relative price movement between the two bonds in Exhibit 1 when interest rates change significantly
During the discussions, Rogers makes the following statements:

Statement 1: If the volatility of interest rates decreases, the value of the callable bond will increase.
Statement 2: The noncallable bond will not be affected by a change in the volatility or level of interest rates.
Statement 3: When interest rates decrease, the value of the noncallable bond increases by more than the callable bond.
Statement 4: If the volatility of interest rates increases, the value of the putable bond will increase.

Walters mentors Rogers on bond concepts and then asks him to consider the pricing of a third bond. The third bond has five years to maturity, a 6% annual coupon, and pays interest semiannually. The bond is both callable and putable at 100 at any time. Walters indicates that the holders of the bond's embedded options will exercise if the option is in-the-money.



Rogers obtained the prices shown in Exhibit b using software that generates an interest rate lattice. He uses his software to generate the interest rate lattice shown in Exhibit 2.

Exhibit 2: Interest Rate Lattice (Annualized Interest Rates)


Using the information in the question and the following relevant portion of the interest rate and pricing trees, Rogers calculates the value of the noncallable bond at node A.
Corresponding portion of the interest rate tree:



Corresponding portion of the binomial price tree:



The price of the noncallable bond at node A is closest to:

William Rogers, a fixed-income portfolio manager, needs to eliminate a large cash position in his portfolio. He would like to purchase some corporate bonds. Two bonds that he is evaluating are shown in Exhibit I. These two bonds are from the same issuer, and the current call price for the callable bond is 100. Assume that the issuer will call if the bond price exceeds the call price.

Rogers is also concerned about increases in interest rates and is considering the purchase of a putable bond. He wants to determine how assumed increases or decreases in interest rate volatility affect the value of the straight bonds and bonds with embedded options. After Rogers performs some analysis, he and his supervisor, Sigourney Walters, discuss the relative price movement between the two bonds in Exhibit 1 when interest rates change significantly
During the discussions, Rogers makes the following statements:

Statement 1: If the volatility of interest rates decreases, the value of the callable bond will increase.
Statement 2: The noncallable bond will not be affected by a change in the volatility or level of interest rates.
Statement 3: When interest rates decrease, the value of the noncallable bond increases by more than the callable bond.
Statement 4: If the volatility of interest rates increases, the value of the putable bond will increase.

Walters mentors Rogers on bond concepts and then asks him to consider the pricing of a third bond. The third bond has five years to maturity, a 6% annual coupon, and pays interest semiannually. The bond is both callable and putable at 100 at any time. Walters indicates that the holders of the bond's embedded options will exercise if the option is in-the-money.



Rogers obtained the prices shown in Exhibit b using software that generates an interest rate lattice. He uses his software to generate the interest rate lattice shown in Exhibit 2.

Exhibit 2: Interest Rate Lattice (Annualized Interest Rates)


Using the information in the question and the following relevant portion of the interest rate and pricing trees, Rogers calculates the value of the callable bond at node B.

Corresponding portion of the interest rate tree:


Corresponding portion of the callable bond price tree:



The price of the callable bond at node B is closest to:

Jerry Sanders, CFA, has been asked to analyze the 20-year bonds of Marietta Tech, Inc., which are currently being held in a corporate bond portfolio managed by a colleague, and to recommend whether the bonds should be sold or held. The bonds currently have a yield spread of 1.55% over Treasuries.

Marietta Tech, Inc. designs, manufactures, and markets specialty trucks and truck bodies mounted on new truck chassis produced by others, including concrete mixers, refuse bodies, fire and emergency vehicles, defense trucks, cut-away and dry freight van bodies, refrigerated units, stake bodies, and other specialized trucks. Marietta also manufactures fiberglass wind deflectors, armored trucks, shuttle buses, and cargo vans. Marietta's customers are located in the United States and Canada.

Exhibit 1: Selected Financial Data for Marietta Tech, Inc. (in thousands of $)






At lunch Sanders discusses the credit analysis of various types of bonds with Elizabeth Yan, who was just hired as a bond analyst. Yan makes the following statements:

Statement 1: An analysis of the issuer's business and operating risks is important to the analysis of corporate bond credit risk but not important for the credit analysis of asset backed securities (ABS).
Statement 2: The unique bond covenants in a municipal bond's trust indenture require an additional level of credit analysis not necessary in a corporate credit analysis.

After lunch Sanders asks Tatiana Petrovich in the municipal bond department for her opinion on the most important factors in the risk assessment of tax-backed municipal debt. Petrovich identifies three factors:

1. A measure of debt burden, such as debt-per-capita in the tax jurisdiction.
2. An evaluation of tax collection rates and intergovernmental revenue ability.
3. Analysis of the municipality's budgetary policies as an indication of financial discipline.

Sanders first analyzes Marietta's 2008 EBIT-to-interest expense and EBITDA-to-interest expense and compares them to the median ratios from Exhibit 2. Relative to the BBB medians for the respective ratios: