Natalia Berg, CFA, has estimated the key rate durations for several maturities in three of her $25 million bond portfolios, as shown in Exhibit 1.At a fixed-income conference in London, Berg hears a presentation by a university professor on the increasing use of the swap rate curve as a benchmark instead of the government bond yield curve. When Berg returns from the conference, she realizes she has left her notes from the presentation on the airplane. However, she is very interested in learning more about whether she should consider using the swap rate curve in her work.As she tries to reconstruct what was said at the conference, she writes down two advantages to using the swap rate curve:Statement 1: The swap rate curve typically has yield quotes at 11 maturities between 2 and 30 years. The U.S. government bond yield curve, however, has fewer on-the-run issues trading at maturities of at least two years.Statement 2: Swap curves across countries are more comparable than government bond curves because they reflect similar levels of credit risk.Berg also estimates the nominal spread, Z-spread, and option-adjusted spread (OAS) for the Steigers Corporation callable bonds in Portfolio 2. The OAS is estimated from a binomial interest rate tree. The results are shown in Exhibit 2.Berg determines that to obtain an accurate estimate of the effective duration and effective convexity of a callable bond using a binomial model, the specified change in yield (i.e., Ay) must be equal to the OAS.Berg also observes that the current Treasury bond yield curve is upward sloping. Based on this observation, Berg forecasts that short-term interest rates will increase.The most appropriate conclusion to draw from Berg's analysis of the Steigers Corp callable bond is that the bond is relatively:
Answer(s): B
If the benchmark is Treasuries or a bond sector (with a credit rating higher than the bond we're valuing), any callable corporate bond with an OAS less than or equal to zero is overvalued relative to the benchmark because it must have more credit risk, and most likely more liquidity risk, than the benchmark. If the OAS is positive, the callable bond is undervalued relative to the benchmark only if the OAS is greater than the required OAS. In this question we aren't given the required OAS relative to a Treasury benchmark, so we can't draw any conclusions from the Steigers Corp. callable bond's OAS relative to Treasuries.If we use an issuer-specific benchmark (assuming relative liquidity risk is zero), the callable bond is undervalued relative to the benchmark if the OAS is positive, fairly valued if the OAS is zero, and overvalued if the OAS is negative. In this question the OAS relative to Steigers" spot rate curve is negative, which means the callable bond is overvalued. (Study Session 14, LOS 54.a,g)
Natalia Berg, CFA, has estimated the key rate durations for several maturities in three of her $25 million bond portfolios, as shown in Exhibit 1.At a fixed-income conference in London, Berg hears a presentation by a university professor on the increasing use of the swap rate curve as a benchmark instead of the government bond yield curve. When Berg returns from the conference, she realizes she has left her notes from the presentation on the airplane. However, she is very interested in learning more about whether she should consider using the swap rate curve in her work.As she tries to reconstruct what was said at the conference, she writes down two advantages to using the swap rate curve:Statement 1: The swap rate curve typically has yield quotes at 11 maturities between 2 and 30 years. The U.S. government bond yield curve, however, has fewer on-the-run issues trading at maturities of at least two years.Statement 2: Swap curves across countries are more comparable than government bond curves because they reflect similar levels of credit risk.Berg also estimates the nominal spread, Z-spread, and option-adjusted spread (OAS) for the Steigers Corporation callable bonds in Portfolio 2. The OAS is estimated from a binomial interest rate tree. The results are shown in Exhibit 2.Berg determines that to obtain an accurate estimate of the effective duration and effective convexity of a callable bond using a binomial model, the specified change in yield (i.e., Ay) must be equal to the OAS.Berg also observes that the current Treasury bond yield curve is upward sloping. Based on this observation, Berg forecasts that short-term interest rates will increase.Is Berg correct about the specified change in yield needed to obtain an accurate estimate of the effective duration and effective convexity of a callable bond using a binomial model?
Answer(s): C
The steps in the process of calculating the effective duration of a callable bond using a binomial tree are as follows:Step 1: Given assumptions about benchmark interest rates, interest rate volatility, and the call and/or put rule, calculate the OAS for the issue using the binomial model.Step 2: Impose a small parallel shift in the on-the-run yield curve by an amount equal to Step 3: Build a new binomial interest rate tree using the new yield curve.Step 4: Add the OAS to each of the 1-year forward rates in the interest rate tree to get a "modified" tree. (We assume that the OAS does not change when interest rates change.)Step 5: Compute using this modified interest rate tree.Step 6: Repeat steps 2 through 5 using a parallel rate shift of to estimate a value of There is no restriction on the relationship between the assumed change in the yield and the OAS. (Study Session 14, LOS 54.h)
Natalia Berg, CFA, has estimated the key rate durations for several maturities in three of her $25 million bond portfolios, as shown in Exhibit 1.At a fixed-income conference in London, Berg hears a presentation by a university professor on the increasing use of the swap rate curve as a benchmark instead of the government bond yield curve. When Berg returns from the conference, she realizes she has left her notes from the presentation on the airplane. However, she is very interested in learning more about whether she should consider using the swap rate curve in her work.As she tries to reconstruct what was said at the conference, she writes down two advantages to using the swap rate curve:Statement 1: The swap rate curve typically has yield quotes at 11 maturities between 2 and 30 years. The U.S. government bond yield curve, however, has fewer on-the-run issues trading at maturities of at least two years.Statement 2: Swap curves across countries are more comparable than government bond curves because they reflect similar levels of credit risk.Berg also estimates the nominal spread, Z-spread, and option-adjusted spread (OAS) for the Steigers Corporation callable bonds in Portfolio 2. The OAS is estimated from a binomial interest rate tree. The results are shown in Exhibit 2.Berg determines that to obtain an accurate estimate of the effective duration and effective convexity of a callable bond using a binomial model, the specified change in yield (i.e., Ay) must be equal to the OAS.Berg also observes that the current Treasury bond yield curve is upward sloping. Based on this observation, Berg forecasts that short-term interest rates will increase.Is Berg's short-term interest rate forecast consistent with the pure expectations theory and the liquidity premium theory?
An upward sloping yield curve predicts an increase in short-term rates according to the pure expectations theory but not necessarily the liquidity premium theory.The liquidity theory says that forward rates are a biased estimate of the market's expectation of future rates because they include a liquidity premium. Therefore, a positive sloping yield curve may indicate either (1) that the market expects future interest rates to rise or (2) that rates are expected to remain constant (or even fall), but the addition of the liquidity premium results in a positive slope. (Study Session 14, LOS 53.e)
Kylie Autumn, CFA, is a consultant with Tri-Vision Group. Robert Lullum, Senior Vice President at Langsford Investments, has asked for assistance with the evaluation of mortgage-backed and collateralized mortgage obligation (CMO) derivative securities for potential inclusion in several client portfolios. Langsford Investments mainly deals with equity investments and REITs, but the company recently purchased a small firm that invests mainly in fixed-income securities.Lullum has done some research on the appropriate spread measures and option valuation models for fixed-income securities and wants to clarify some points. He wants to know if the following statements are correct:Statement 1: The proper spread measure for option-free corporate bonds is the nominal spread.Statement 2: Callable corporate bonds and mortgage-backed securities should be measured using the option-added spread.Statement 3: The Z-spread is appropriate for credit card ABS and auto loan ABS.While Lullum meets with Autumn, Janet Van Ark, CFA charterholder and equity-income portfolio manager for Langsford, is attempting to purchase bonds that may also provide her with equity exposure in the future. She has decided to analyze an 8% annual coupon bond with exactly 20 years to maturity. The bonds are convertible into 10 common shares for each $ 1,000 of par (face) value. The bond's market price is $920, and the common stock has a market price of $40. Van Ark estimates that the stock will increase in value to $70 within the next two years. The stock's annual dividend is $0.40 per share, and the market yield on comparable non-convertible bonds'is 9.5%.Carl Leighton, a Langsford analyst and Level 2 CFA candidate, works with mortgage-backed and other asset-based securities. He provides Lullum with a list of credit enhancements for asset-backed securities, which includes letters of credit, excess servicing spread funds, over-collateralization, and bond insurance. Lullum then asks him for a status report of the firm's exposure to paythrough securities. He also asks Leighton to calculate the single-monthly mortality rate (SMM) and estimate the prepayment for the month for a seasoned mortgage pool with a $500,000 principal balance remaining. The scheduled monthly principal payment is $ 150 and the conditional prepayment rate (CPR) is 7%.Autumn should tell Lullum that the most appropriate models for valuing the option on mortgage-backed securities (MBS) and credit card asset-backed securities (ABS) are:
Since MBS have an embedded option (prepayment option) that is typically exercised and is path dependent, the appropriate valuation model is Monte Carlo simulation. Credit card ABS do not have an embedded option, so neither valuation model is needed. A simple discounted cash flow model is sufficient. (Study Session 15. LOS 57.i)
Kylie Autumn, CFA, is a consultant with Tri-Vision Group. Robert Lullum, Senior Vice President at Langsford Investments, has asked for assistance with the evaluation of mortgage-backed and collateralized mortgage obligation (CMO) derivative securities for potential inclusion in several client portfolios. Langsford Investments mainly deals with equity investments and REITs, but the company recently purchased a small firm that invests mainly in fixed-income securities.Lullum has done some research on the appropriate spread measures and option valuation models for fixed-income securities and wants to clarify some points. He wants to know if the following statements are correct:Statement 1: The proper spread measure for option-free corporate bonds is the nominal spread.Statement 2: Callable corporate bonds and mortgage-backed securities should be measured using the option-added spread.Statement 3: The Z-spread is appropriate for credit card ABS and auto loan ABS.While Lullum meets with Autumn, Janet Van Ark, CFA charterholder and equity-income portfolio manager for Langsford, is attempting to purchase bonds that may also provide her with equity exposure in the future. She has decided to analyze an 8% annual coupon bond with exactly 20 years to maturity. The bonds are convertible into 10 common shares for each $ 1,000 of par (face) value. The bond's market price is $920, and the common stock has a market price of $40. Van Ark estimates that the stock will increase in value to $70 within the next two years. The stock's annual dividend is $0.40 per share, and the market yield on comparable non-convertible bonds'is 9.5%.Carl Leighton, a Langsford analyst and Level 2 CFA candidate, works with mortgage-backed and other asset-based securities. He provides Lullum with a list of credit enhancements for asset-backed securities, which includes letters of credit, excess servicing spread funds, over-collateralization, and bond insurance. Lullum then asks him for a status report of the firm's exposure to paythrough securities. He also asks Leighton to calculate the single-monthly mortality rate (SMM) and estimate the prepayment for the month for a seasoned mortgage pool with a $500,000 principal balance remaining. The scheduled monthly principal payment is $ 150 and the conditional prepayment rate (CPR) is 7%.Autumn should tell Lullum that the most appropriate models for valuing the option on mortgage- backed securities (MBS) and credit card asset-backed securities (ABS) are:
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