Free CFA-Level-II Exam Braindumps
CFA Level II Chartered Financial Analyst Questions 18–22 (page: 65)

The Wyroman International Pension Fund includes a $65 million fixed-income portfolio managed by Susan Evermore, CFA, of Brighton Investors. Evermore is in the process of constructing a binomial interest-rate tree that generates arbitrage-free values for on-the-run Treasury securities. She plans to use the tree to value more complex bonds with embedded options. She starts out by observing that the yield on a one-year Treasury security is 4.0%. She determines in her initial attempt to price the two-year Treasury security that the value derived from the model is higher than the Treasury security's current market price.

After several iterations Evermore determines that the interest rate tree that correctly values the one and two-year Treasury securities has a rate of 5.0% in the lower node at the end of the first year and a rate of 7.5% in the upper node at the end of the first year. She uses this tree to value a two-year 6% coupon bond with annual coupon payments that is callable in one year at 99.50. She determines that the present value at the end of the first year of the expected value of the bond's remaining cash flows is $98.60 if the interest rate is 7.5% and $100.95 if the interest rate is 5.0%.
Note: Assume Evermore's calculations regarding the two-year 6% callable bond are correct

Evermore also uses the same interest rate tree to price a 2-year 6% coupon bond that is putable in one year, and value the embedded put option. She concludes that if the yield volatility decreases unexpectedly, the value of the putable bond will increase and the value of the embedded put option will also increase, assuming all other inputs are unchanged.

Evermore also uses the interest rate tree to estimate the option-adjusted spreads of two additional callable corporate bonds, as shown in the following figure.



Evermore concludes, based on this information, that the A A-rated issue is undervalued, and the BB-rated issue is overvalued.

At a subsequent meeting with the trustees of the fund. Evermore is asked to explain what a binomial interest rate model is and how it was used to estimate effective duration and effective convexity. Evermore is uncertain of the exact methodology because the actual calculations were done by a junior analyst, but she tries to provide the trustees with a reasonably accurate step-by-step description of the process:

Step 1: Given the bond's current market price, the on-the-run Treasury yield curve, and an assumption about rate volatility, create a binomial interest rate tree.
Step 2: Add 100 basis points to each of the 1-year rates in the interest rate tree to derive a "modified" tree.
Step 3: Compute the price of the bond if yield increases by 100 basis points using this new tree.
Step 4: Repeat Steps 1 through 3 to determine the bond price that results from a 100 basis point decrease in rates.
Step 5: Use these two price estimates, along with the original market price, to calculate effective duration and effective convexity.

Lucas Davenport, a trustee and university finance professor, immediately speaks up to disagree with Evermore. He claims that a more accurate description of the process is as follows:
Step 1: Given the bond's current market price, the Treasury yield curve, and an assumption about rate volatility, create a binomial interest rate tree and calculate the bond's option-adjusted spread (OAS) using the model.
Step 2: Impose a parallel upward shift in the on-the-run Treasury yield curve of 100 basis points.
Step 3: Build a new binomial interest rate tree using the new Treasury yield curve and the original rate volatility assumption.
Step 4: Add the OAS from Step I to each of the 1-year rates on the tree to derive a "modified" tree. Step 5: Compute the price of the bond using this new tree.
Step 6: Repeat Steps 1 through 5 to determine the bond price that results from a 100 basis point decrease in rates.
Step 7: Use these two price estimates, along with the original market price, to calculate effective duration and effective convexity.

At the meeting with the trustees. Evermore also presents the results of her analysis of the effect of changing market volatilities on a 1-year convertible bond issued by Highfour Corporation. Each bond is convertible into 25 shares of Highfour common stock. The bond is also callable at 110 at any time prior to maturity. She concludes that the value of the bond will decrease if either (1) the volatility of returns on'Highfour common stock decreases or (2) yield volatility decreases.

Davenport immediately disagrees with her by saying "changes in the volatility of common stock returns will have no effect on the value of the convertible bond, and a decrease in yield volatility will result in an increase in the value of the bond."

For this question, analyze each effect separately. Is Davenport correct in disagreeing with Evermore's conclusions regarding the effect on the value of the convertible bond resulting from a change in volatility?

Wendall Wayne is a fixed income portfolio manager with Skyline Investments. Until recently he has focused almost exclusively on residential mortgage-backed securities (MBS). However, two weeks ago he was given approval to begin purchasing asset-backed securities (ABS) and commercial MBS as well. Wayne has forecasted that interest rates will decrease by approximately 100 basis points over the next month.

Wayne first completes an analysis of two tranches (a PAC I tranche and a support tranche) from a collateralized mortgage obligation (CMO) that was issued 18 months ago. When the CMO was issued, the initial collar of the PAC I tranche was 150 - 400 PSA. He estimates the change in the average life of each tranche as the prepayment speed varies, assuming the prepayment speed stays at that speed until the tranche matures. The results are shown in Exhibit 1.


In his report, Wayne makes the following statements regarding the CMO:
Statement 1: The CMO is structured so that the support tranche has more extension risk, and the PAC I tranche has more contraction risk.

Statement 2: The cash flows of the PAC I tranche will be less affected by the change in interest rates I have forecast than the cash flows of the support tranche.
Wayne has pushed for approval to begin trading ABS because he is particularly interested in collateralized debt obligations (CDOs). However, he doesn't know a lot about them, so he first does some reading and prepares some key points related to CDOs to guide his analysis.

Statement 3: CDOs are typically collateralized by emerging market bond issues, home equity bank loans, and high-yield corporate bond issues.

Statement 4: One advantage of issuing a synthetic CDO versus a cash CDO is that credit risk is lower with a synthetic CDO because the junior note holders also sell a credit default swap.

Statement 5: Some CDOs include an equity tranche to provide payment and credit protection to the senior and mezzanine tranches, but for most issues, credit protection is provided by external credit enhancements.
Wayne wants to understand the distinction between amortizing and non-amortizing assets that are securitized by ABS transactions, as well as the appropriate spread measures to use for various types of fixed-income securities. He asks a colleague, Martin Freed, to explain to him the difference between the two and how the payment structure of the ABS is affected by whether the assets in the pool are amortizing or non-amortizing. Freed replies:

Statement 6: An auto loan is an example of an amortizing asset, and a credit card receivable is an example of a non-amortizing asset.

Statement 7: For amortizing assets, the composition of the loans in the asset pool doesn't change once the assets are securitized. For non-amortizing assets, the composition of the asset pool does change.

Freed also tells Wayne that the credit analysis of commercial mortgage-backed securities (CMBS) should focus on the credit risk of the property, not the borrower. Freed also says that two key ratios useful for assessing the credit risk of the property are the debt service coverage ratio (net operating income/debt service) and the loan-to-value ratio (current mortgage amount/current appraised value). Wayne concludes that both of the ratios Freed recommends for credit analysis of CMBS are positively related to credit risk: the higher the ratio, the more risky the loan.

Finally, Wayne is trying to determine the most appropriate spread measure for valuing callable corporate bonds and high-quality home equity loan ABS. He plans to choose from the following measures: the zero-volatility spread, the OAS from the binomial model, and the OAS from the Monte Carlo model.

Which of the two tranches (XX or YY) is most likely the support tranche, and what is the effective collar of the PAC 1 tranche?

Support tranche Effective collar of PAC 1 tranche

Wendall Wayne is a fixed income portfolio manager with Skyline Investments. Until recently he has focused almost exclusively on residential mortgage-backed securities (MBS). However, two weeks ago he was given approval to begin purchasing asset-backed securities (ABS) and commercial MBS as well. Wayne has forecasted that interest rates will decrease by approximately 100 basis points over the next month.

Wayne first completes an analysis of two tranches (a PAC I tranche and a support tranche) from a collateralized mortgage obligation (CMO) that was issued 18 months ago. When the CMO was issued, the initial collar of the PAC I tranche was 150 - 400 PSA. He estimates the change in the average life of each tranche as the prepayment speed varies, assuming the prepayment speed stays at that speed until the tranche matures. The results are shown in Exhibit 1.


In his report, Wayne makes the following statements regarding the CMO:
Statement 1: The CMO is structured so that the support tranche has more extension risk, and the PAC I tranche has more contraction risk.

Statement 2: The cash flows of the PAC I tranche will be less affected by the change in interest rates I have forecast than the cash flows of the support tranche.
Wayne has pushed for approval to begin trading ABS because he is particularly interested in collateralized debt obligations (CDOs). However, he doesn't know a lot about them, so he first does some reading and prepares some key points related to CDOs to guide his analysis.

Statement 3: CDOs are typically collateralized by emerging market bond issues, home equity bank loans, and high-yield corporate bond issues.

Statement 4: One advantage of issuing a synthetic CDO versus a cash CDO is that credit risk is lower with a synthetic CDO because the junior note holders also sell a credit default swap.

Statement 5: Some CDOs include an equity tranche to provide payment and credit protection to the senior and mezzanine tranches, but for most issues, credit protection is provided by external credit enhancements.
Wayne wants to understand the distinction between amortizing and non-amortizing assets that are securitized by ABS transactions, as well as the appropriate spread measures to use for various types of fixed-income securities. He asks a colleague, Martin Freed, to explain to him the difference between the two and how the payment structure of the ABS is affected by whether the assets in the pool are amortizing or non-amortizing. Freed replies:

Statement 6: An auto loan is an example of an amortizing asset, and a credit card receivable is an example of a non-amortizing asset.

Statement 7: For amortizing assets, the composition of the loans in the asset pool doesn't change once the assets are securitized. For non-amortizing assets, the composition of the asset pool does change.

Freed also tells Wayne that the credit analysis of commercial mortgage-backed securities (CMBS) should focus on the credit risk of the property, not the borrower. Freed also says that two key ratios useful for assessing the credit risk of the property are the debt service coverage ratio (net operating income/debt service) and the loan-to-value ratio (current mortgage amount/current appraised value). Wayne concludes that both of the ratios Freed recommends for credit analysis of CMBS are positively related to credit risk: the higher the ratio, the more risky the loan.

Finally, Wayne is trying to determine the most appropriate spread measure for valuing callable corporate bonds and high-quality home equity loan ABS. He plans to choose from the following measures: the zero-volatility spread, the OAS from the binomial model, and the OAS from the Monte Carlo model.

Regarding the CMO, are Wayne's statements correct?

Wendall Wayne is a fixed income portfolio manager with Skyline Investments. Until recently he has focused almost exclusively on residential mortgage-backed securities (MBS). However, two weeks ago he was given approval to begin purchasing asset-backed securities (ABS) and commercial MBS as well. Wayne has forecasted that interest rates will decrease by approximately 100 basis points over the next month.

Wayne first completes an analysis of two tranches (a PAC I tranche and a support tranche) from a collateralized mortgage obligation (CMO) that was issued 18 months ago. When the CMO was issued, the initial collar of the PAC I tranche was 150 - 400 PSA. He estimates the change in the average life of each tranche as the prepayment speed varies, assuming the prepayment speed stays at that speed until the tranche matures. The results are shown in Exhibit 1.


In his report, Wayne makes the following statements regarding the CMO:
Statement 1: The CMO is structured so that the support tranche has more extension risk, and the PAC I tranche has more contraction risk.

Statement 2: The cash flows of the PAC I tranche will be less affected by the change in interest rates I have forecast than the cash flows of the support tranche.
Wayne has pushed for approval to begin trading ABS because he is particularly interested in collateralized debt obligations (CDOs). However, he doesn't know a lot about them, so he first does some reading and prepares some key points related to CDOs to guide his analysis.

Statement 3: CDOs are typically collateralized by emerging market bond issues, home equity bank loans, and high-yield corporate bond issues.

Statement 4: One advantage of issuing a synthetic CDO versus a cash CDO is that credit risk is lower with a synthetic CDO because the junior note holders also sell a credit default swap.

Statement 5: Some CDOs include an equity tranche to provide payment and credit protection to the senior and mezzanine tranches, but for most issues, credit protection is provided by external credit enhancements.
Wayne wants to understand the distinction between amortizing and non-amortizing assets that are securitized by ABS transactions, as well as the appropriate spread measures to use for various types of fixed-income securities. He asks a colleague, Martin Freed, to explain to him the difference between the two and how the payment structure of the ABS is affected by whether the assets in the pool are amortizing or non-amortizing. Freed replies:

Statement 6: An auto loan is an example of an amortizing asset, and a credit card receivable is an example of a non-amortizing asset.

Statement 7: For amortizing assets, the composition of the loans in the asset pool doesn't change once the assets are securitized. For non-amortizing assets, the composition of the asset pool does change.

Freed also tells Wayne that the credit analysis of commercial mortgage-backed securities (CMBS) should focus on the credit risk of the property, not the borrower. Freed also says that two key ratios useful for assessing the credit risk of the property are the debt service coverage ratio (net operating income/debt service) and the loan-to-value ratio (current mortgage amount/current appraised value). Wayne concludes that both of the ratios Freed recommends for credit analysis of CMBS are positively related to credit risk: the higher the ratio, the more risky the loan.

Finally, Wayne is trying to determine the most appropriate spread measure for valuing callable corporate bonds and high-quality home equity loan ABS. He plans to choose from the following measures: the zero-volatility spread, the OAS from the binomial model, and the OAS from the Monte Carlo model.

How many of Wayne's observations related to CDOs (Statement 3, Statement 4, and Statement 5) are correct?

Wendall Wayne is a fixed income portfolio manager with Skyline Investments. Until recently he has focused almost exclusively on residential mortgage-backed securities (MBS). However, two weeks ago he was given approval to begin purchasing asset-backed securities (ABS) and commercial MBS as well. Wayne has forecasted that interest rates will decrease by approximately 100 basis points over the next month.

Wayne first completes an analysis of two tranches (a PAC I tranche and a support tranche) from a collateralized mortgage obligation (CMO) that was issued 18 months ago. When the CMO was issued, the initial collar of the PAC I tranche was 150 - 400 PSA. He estimates the change in the average life of each tranche as the prepayment speed varies, assuming the prepayment speed stays at that speed until the tranche matures. The results are shown in Exhibit 1.


In his report, Wayne makes the following statements regarding the CMO:
Statement 1: The CMO is structured so that the support tranche has more extension risk, and the PAC I tranche has more contraction risk.

Statement 2: The cash flows of the PAC I tranche will be less affected by the change in interest rates I have forecast than the cash flows of the support tranche.
Wayne has pushed for approval to begin trading ABS because he is particularly interested in collateralized debt obligations (CDOs). However, he doesn't know a lot about them, so he first does some reading and prepares some key points related to CDOs to guide his analysis.

Statement 3: CDOs are typically collateralized by emerging market bond issues, home equity bank loans, and high-yield corporate bond issues.

Statement 4: One advantage of issuing a synthetic CDO versus a cash CDO is that credit risk is lower with a synthetic CDO because the junior note holders also sell a credit default swap.

Statement 5: Some CDOs include an equity tranche to provide payment and credit protection to the senior and mezzanine tranches, but for most issues, credit protection is provided by external credit enhancements.
Wayne wants to understand the distinction between amortizing and non-amortizing assets that are securitized by ABS transactions, as well as the appropriate spread measures to use for various types of fixed-income securities. He asks a colleague, Martin Freed, to explain to him the difference between the two and how the payment structure of the ABS is affected by whether the assets in the pool are amortizing or non-amortizing. Freed replies:

Statement 6: An auto loan is an example of an amortizing asset, and a credit card receivable is an example of a non-amortizing asset.

Statement 7: For amortizing assets, the composition of the loans in the asset pool doesn't change once the assets are securitized. For non-amortizing assets, the composition of the asset pool does change.

Freed also tells Wayne that the credit analysis of commercial mortgage-backed securities (CMBS) should focus on the credit risk of the property, not the borrower. Freed also says that two key ratios useful for assessing the credit risk of the property are the debt service coverage ratio (net operating income/debt service) and the loan-to-value ratio (current mortgage amount/current appraised value). Wayne concludes that both of the ratios Freed recommends for credit analysis of CMBS are positively related to credit risk: the higher the ratio, the more risky the loan.

Finally, Wayne is trying to determine the most appropriate spread measure for valuing callable corporate bonds and high-quality home equity loan ABS. He plans to choose from the following measures: the zero-volatility spread, the OAS from the binomial model, and the OAS from the Monte Carlo model.

Based on the material he has read concerning ABS, Wayne disagrees with Freed's Statement 6 but agrees with Statement 7. In fact: